Economic Commentary | First Quarter 2019

The stock market performed quite well during the First Quarter of 2019 despite opening with what would turn out to be the longest US government shutdown ever; slowing manufacturing sectors in the US, Europe, and China; and bond yields falling. For the quarter, the large cap S&P 500 index rose 13.6%, the mid/small cap Russell 2000 index gained 14.6%, the international MSCI EAFE index grew 10.0%, and the emerging markets MSCI EM advanced 9.6%.

The dominant story this quarter centered on the US-China trade war. As it became apparent to American and Chinese leaders that the trade war would inflict real pain on both economies, the two governments began to consider various measures to combat the tariffs’ drag on economic growth. In a bid to boost lending, China announced in early January that it would reduce the reserves required to be held by banks. Shortly thereafter, China reported that its Fourth Quarter 2018 GDP gained 6.4%, the slowest pace in ten years, and its 2018 GDP grew by 6.6%, its slowest pace in almost thirty years. Chinese premier Li Keqiang highlighted the importance of 2019 to the government’s long-term strategy and reiterated his commitment to the private sector and to market-based solutions, announcements which were accompanied by tax cuts to boost consumer spending. It is worth pointing out that China is dealing with a brand-new problem created by its recent reforms…the rise of the consumer class, which is driving the slowdown. In the past, Beijing had almost complete control over the various financial levers in its economy; however, with the shift to a more market-oriented economy, consumers have power they have never before enjoyed, which also means that the government has never had this little power before. This shift has resulted in new challenges to the leadership of Xi Jinping as he navigates bringing China onto the world economic stage and ceding the control that China has always exerted over its economy.

The US economy grew in 2018 by 2.9% ~ the strongest growth in four years ~ but Jay Powell was in the hot seat as Trump levied complaints that growth was not more robust. Powell took great care throughout the quarter to reassure markets that the Fed would not make a policy mistake by raising rates too aggressively in 2019. Powell’s “patient” approach was supported by a deteriorating economic picture: the slowdown in China and Europe; geopolitical tensions arising from Brexit and the US trade wars; and a housing market that appeared to be slowing. With each subsequent report of moderating economic activity, the market cheered as the new data took future rate hikes off the table for 2019.

The slowdown in the global economy became more apparent as we moved through the quarter, with particular weakness coming from Europe as it experienced the fallout from the US-China trade war. German manufacturing took an especially hard hit, while Italy faced budget woes, and France was inundated with the yellow vest protests. The persistent negative attention arising from the failed Brexit negotiations did not help matters, and eurozone GDP grew only 1.2%, its slowest pace in four years as Italy slipped into recession. In response, the European Central Bank continues to employ negative interest rate policies and has revived a program that allows commercial banks to borrow at 0% as long as they lend the funds to businesses or consumers.

The International Monetary Fund reduced its global growth estimate from 3.9% last July to 3.7% in October and then further to 3.5% in January. The IMF outlook became more subdued as a result of various trade tensions, slowing demand across Europe, and moderating global expansion driven by a slowdown in China. If this bears out and global growth does approach 3.5% this year, it will be the weakest growth rate in three years.

Despite a slower growth environment, energy rallied this quarter as oil prices gained 32% during the quarter on reduced oil supplies as OPEC cut output, the US imposed sanctions on Venezuela, and Libya’s renewed violence suppressed production. The US labor market has also remained resilient, with the JOLTs (Job Openings and Labor Turnover survey) rising to a new record high of 7.6M jobs available in March. Employers created an average of 189K jobs per month, a remarkable figure given the late stage of this expansion. While the February figure (the last reported during the quarter in March) was quite weak, it ended up being a blip as the March report that we saw in April bounced back to an impressive gain of 196K jobs. Wage gains continue to frustrate, as they have lagged the rosier picture of the overall jobs market; however, we did see a gain of 3.4% in hourly earnings in the latest report. Encouragingly, the savings rate for US households as a percent of discretionary income is now back to 7.5%, which is approaching its historical norm of 8.3%.

There has been much coverage by the media in recent months surrounding the flattening of the yield curve, which briefly inverted as the ten-year Treasury yield fell below the rate on the 90-Day Treasury. Such a yield curve inversion, if it persists, has historically been an accurate predictor of recessions. While every recession since the mid-1960s has been preceded by a yield curve inversion, we have also seen some false positives in which inversions did not predict a coming recession. It remains unclear whether we will remain at these persistently low yields; however, such historically depressed yields do signify low inflation expectations and reduced confidence in economic growth. Even if this yield curve inversion does persist, history shows us that the length of time to a subsequent recession and its duration remain quite variable. As you know, we do not attempt to time the market, but we do expect that our managers will take the risk of a slowing economy into account when positioning their portfolios. It is also helpful to remember that times of market turbulence provide the best opportunities for our managers to buy stellar companies at cheaper prices.