During Q1, financial markets responded favorably to the US Federal Reserve’s shift away from its monetary tightening bias. Most economic indicators remained tepid, although China displayed some initial signs of stabilizing activity. The mature global business cycle continues to warrant smaller cyclical allocation tilts and the prioritization of portfolio diversification.
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In a reversal from the sharp downturn in Q4 2018, prices for riskier assets posted substantial gains during Q1 2019. Global equity markets rallied, with the US leading the way. High-yield corporate bonds and commodities also rebounded.
US Treasury bond yields continued their descent, boosting returns to high-quality bonds and solidifying positive results across all major asset categories. The 10-year Treasury bond yields fell below 3-month Treasuries, inverting the yield curve.
Globally, government bond yields continued to decline, with 10-year yields in Germany and Japan revisiting negative territory. It remains to be seen whether Q1 represents a risk-asset relief rally in reaction to a monetary shift, or whether it portends a more lasting upturn in the global economy.
Economy/macro backdrop: Mature US, global business cycles
Global growth remains positive but has become more uneven, and many major economies have progressed toward more advanced stages of the business cycle. The US is firmly in late cycle but with low near-term risk of recession. China's growth recession weighed on industrial sectors in Europe and other export economies, but policy stimulus appears to have begun stabilizing its growth trajectory.
Leading economic indicators continue to point to global headwinds. US indicators no longer diverge from the weak global backdrop. Meanwhile, China's policymakers stepped up the pace of fiscal and monetary stimulus this quarter, but credit growth remains subdued, well below prior periods of stimulus. It remains unclear whether policy actions are sufficient to reaccelerate China’s economy, implying high debt levels may still be inhibiting the policy response.
US workers continue to reenter the labor force amid cyclically low unemployment rates. Tight labor markets have spurred accelerating wage growth, which is typical during late cycle and provides support to US consumer spending. A rising number of US states are reporting higher initial unemployment claims, which may be an early sign of peaking employment growth. Recent weakness in housing activity also is consistent with late-cycle trends.
Heading into Q4 2018, the Federal Reserve expressed a baseline plan to raise rates 5 more times during this tightening cycle; market expectations, meanwhile, were for 3 more rate hikes. After raising rates once in December, the late 2018 market downturn and weak economic data spurred the Fed during Q1 to communicate an indefinite pause in its rate tightening. Market expectations switched to anticipating a rate cut during 2019.
The Fed announced plans to end its quantitative tightening by terminating balance-sheet reductions before year end; meanwhile, the European Central Bank signaled possible balance-sheet expansion. Nevertheless, growth in major central-bank balance sheets likely will stay negative for most of 2019.
During Q1, 10-year Treasuries fell below 3-month Treasury yields, inverting the yield curve. Curve inversions have preceded the past 7 recessions and may be interpreted as a signal of weaker expectations relative to current conditions. Since 1965, however, the time between inversion and recession has varied significantly, and there have been 2 "head fakes" in which the curve re-steepened and expansion continued.
A flatter yield curve has challenged banks’ profitability by shrinking the gap between lending rates and funding costs, leading to tighter credit standards in some loan categories.
Our current outlook is for core inflation to stay firm near-term, with the base effect of weaker oil prices likely to pull overall inflation downward. The Fed is more likely to be patient if inflation remains low and credit conditions mixed.
Investors remained hopeful for a US-China trade deal that could deliver near-term relief from tariff escalation. However, a budding geopolitical rivalry may make a variety of other bilateral commercial issues less tractable, particularly strategic competition in the technology sector. This rivalry represents a critical ongoing risk to the highly integrated global economy.
Although we think global economic momentum has peaked, recent changes in policy stances in the US and China are supportive of asset markets and of the business cycle overall. Risks include monetary and trade policy uncertainty, as well as China’s uncertain outlook and policy response. We believe the current environment warrants smaller asset allocation tilts and a diversified strategy.
Asset markets: Tech and growth stocks lead broad risk-asset rally
The US mid cap and growth equity segments stood out as top performers for the quarter. Overall, US stocks outperformed international stocks. Fixed income assets posted positive returns across the board, with higher-risk areas such as high-yield corporate credit and emerging-market debt leading the way. Prices for most industrial commodities bottomed during Q1, with oil and copper staging rallies.
Historically, the mid-cycle phase has consistently tended to favor riskier asset classes and result in broad-based gains across most asset categories. Meanwhile, late cycle has had the most mixed performance of any business-cycle phase. Late cycle often has featured more limited overall upside for a diversified portfolio, although returns for most categories have been positive, on average. Since 1950, late-cycle phases have ranged in length from less than a year to more than 2 years.
US earnings growth remained high but decelerated during Q1 after receiving a boost from corporate tax cuts in 2018. Non-US developed- and emerging-market profit growth, however, moved into negative territory during the quarter. Forward estimates point to market expectations for a convergence of global profit growth in the mid-single-digit range over the next 12 months.
Using 5-year peak-inflation-adjusted earnings, P/E ratios for international developed- and emerging-market equities remain lower than those for the US, providing a relatively favorable long-term valuation backdrop for non-US stocks. After appreciating during 2018, the US dollar was mostly unchanged over Q1, with mixed valuations versus many of the world’s major currencies at quarter end. Meanwhile, investment-grade spreads tightened during the quarter to end near long-term averages.
In fixed income, weak growth, modest inflation, and the Fed's dovish shift fueled a decline in yields. Lower interest rates, coupled with tighter credit spreads, pushed yields on most bond categories near the bottom quartile of their long-term histories. Spreads fell more abruptly in lower-quality categories such as high-yield and emerging-market debt, moving their spreads back below historical averages.
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