Outlook: Second quarter 2019

Economy

Growth in the U.S. economy continues to moderate from the high levels of 2018 and is reverting toward the long-term trend of two percent. The economy is slowing for a myriad of reasons including the fading impact of last year’s tax reform, the sustained tightening of monetary policy since December of 2015, the trade dispute with China and weakness in some foreign countries. Given the slowing trajectory and the volatility in the equity markets late last year, the Federal Reserve made a significant pivot last quarter. Their guidance for rate hikes was cut substantially and they now expect to leave rates constant this year versus prior expectations of two hikes in 2019. They have also tempered their guidance for the reduction of their balance sheet. Clearly, the Federal Reserve has shifted from a policy constraining growth to one that is geared to extend the current expansion. 

Inflation

Inflation remains relatively subdued. After peaking at close to 3.0 percent last July, current readings indicate that inflation has fallen and is now at a rate of approximately 2.0 percent. Looking forward, we expect price levels to remain contained as the pace of economic growth is moderating.

U.S. Dollar

The U.S. dollar has been climbing steadily since early last year as the narrative around a synchronized global expansion deteriorated. Growth in foreign economies has been relatively soft and the U.S. has, until recently, been raising interest rates. Accordingly, the dollar has been strong and is trading at high levels against most currencies. Our currency remained strong last quarter despite the conciliatory shift in policy by the Federal Reserve and the subsequent decline in interest rates. This suggests that market participants remain optimistic in their outlook for the U.S. economy. Looking forward, we expect the dollar to remain strong, but we continue to emphasize that trade negotiations with China and the process of developing a Brexit resolution are likely to boost volatility in the currency markets while also providing directional cues based on their outcomes. 

Asset class

Cash/Money

Market Instruments After peaking in December 2018, yields on cash and money market instruments have decreased marginally. The modest decline is a reversal of a trend that began in the fourth quarter of 2015 and is reflective of a shift in monetary policy. The Federal Reserve has dramatically shifted its position since last September, moving to a neutral stance. During September, the 10-year Treasury was around 3.0 percent and expectations were for two more rate hikes for 2018. Today the rate on the 10-year Treasury is close to 2.5 percent and expectations are for no hikes for 2019. In fact, there is a possibility of a rate cut later this year. The sharp reversal in Federal Reserve policy is reflective of benign inflation as well as mixed global economic data. 

Intermediate Government/Credit Bonds

Following the market sell-off which crested at the end of December, both government and corporate bonds have rebounded in 2019. Lower yields in Treasury bonds and tighter spreads in corporate bonds are reflective of a more constructive tone to the market as opposed to the dour mood at the end of last year. With benign inflation, Federal Reserve Chairman Jerome Powell has adopted a dovish tone and signaled both the end of balance sheet normalization and a pause in the movement of federal funds rate. Mixed economic data bolsters the case of increased patience, and a similar tone has been adopted by other central banks as well. Looking forward, we expect interest rates to remain range bound as modest economic growth and muted inflation keep bond yields close to their current levels. 

Tax-Exempt Municipal Bonds

Solid demand for tax free income, as evidenced by strong municipal bond mutual fund inflows, has been one of the primary drivers of the market this year. Investment Company Institute data indicates that more than $22 billion of new cash has flowed into municipal mutual funds so far in 2019, the strongest pace since at least 2007. The impact of the 2018 tax law and its cap on state tax deductions has become increasingly apparent to taxpayers in high tax states. Accordingly, demand should remain robust as we progress through the tax season and that should keep valuations relatively rich compared to taxable bonds. 

U.S. Equity

In the first three months of 2019, investors shifted their focus from the recessionary fears of last December and U.S. stocks generated their best quarterly returns since 2009. The continuation of the economic expansion coupled with the pivot in the Federal Reserve’s guidance, attractive valuations and expectations for modest earnings growth, drove equity markets up strongly. In fact, the S&P 500 Index stood less than 4 percent below its all-time high on March 31. Despite the strong rally, valuations are undemanding and remain close to the long-term average, trading at 16x forward earnings. Looking ahead, we expect the sustained economic expansion and modest earnings growth to continue to drive stock prices higher, but at a slower pace than we enjoyed last quarter.

International Equity

International equities have rallied year-to-date despite softening economic conditions. The drivers are varied and include increased central bank stimulus, expectations for improving trade relations and the pivot in strategy by the Federal Reserve. Looking forward we expect foreign markets to remain mixed driven by the variance of economic growth opportunities, ongoing trade negotiations and the Brexit transition. Given slowing rates of economic growth, monetary policy is increasingly converging towards an easing trajectory with significant stimulus employed in China and a less aggressive stance by the European Central Bank. While the level of economic uncertainty is high in some foreign economies, the valuations on foreign stocks are compelling as they are trading at a substantial discount to U.S. equities. 

Commodity

Commodity prices were mixed once again last quarter. Improving confidence in the sustainability of the economic expansion drove a rebound in cyclical commodities. The energy segment was strong as oil rebounded from the $45 level and closed the period at $60. Industrial metals, such as copper, were also strong last quarter. Agriculture prices were relatively soft. Looking forward, we continue to expect the slower pace of global growth to act as a headwind to higher commodity prices but acknowledge that a positive resolution to the trade dispute could result in at least a short-term rally.

Potential opportunities & risks

Opportunities

The Emergence of New Technologies

The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created a number of investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time. 

The Evolution of Finance

Technological advancements are disrupting traditional methods of banking, finance and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Electronic bill paying services and companies that facilitate cash transfers are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. 

A Shift to Easier Monetary Policy

Central banks have shifted from a tightening bias to a neutral or easing bias which provides support for the equity markets and a continuation of the economic expansion. The Federal Reserve was one of the drivers of the market downturn last year after providing guidance that suggested they would raise rates significantly. Given their recent pivot to a less aggressive stance, futures markets suggest there is a chance of a rate cut by the end of the year. At the same time, the European Central Bank recently announced a program designed to generate more bank lending and China has taken several steps to boost the level of stimulus this year.

Risks

Declining Growth Rates

Monetary policy has shifted to a neutral stance as growth rates for earnings and the economy have moderated this year. However, if the deceleration in growth is too dramatic, asset values may decline as well. 

Trade Disputes & Rising Protectionist Sentiment

Trade tensions between the U.S. and China remain high, although there has been notable improvement in the early stages of 2019. If the dispute is not resolved, tariffs are likely to be a persistent issue, resulting in a significant headwind to the global economic expansion. Notably, the U.S. will also be holding trade discussions with Europe and Japan this quarter and we will be watching how those discussions progress.

Rising Interest Rates and/or Inflation

A shift from the current environment of low interest rates and benign inflation is likely to be problematic if it occurs too rapidly. Structural forces such as aging populations and the proliferation of technology have kept inflation at low levels, but strong labor markets may lead to an increase in wages and could eventually force the Federal Reserve to raise rates aggressively.

Increasing Government Regulation of Technology Companies

Several of the leading technology companies have established dominant market positions and have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical Risks

Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We continue to monitor events across the Middle East and in the South China Sea.

Debt Related Issues

Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt-financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.

Cybersecurity

Cybersecurity has become a significant issue as evidenced by the Equifax data breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions. The global cost of cybercrime was recently estimated at $600 billion annually, up 20 percent from 2014.

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