Fundamentals Suggest Impressive Risk-On Recovery Will Continue

Of course, the key drivers of equity valuations are earnings and interest rates. Expected corporate EPS growth is only about 5% for 2019 (down from 23% growth in 2018), and some commentators are seeing the slowdown in Q4 GDP growth and the possibility of an outright earnings recession in Q1 as evidence that we are in a late-cycle economy, with a recession on the horizon. But to me, all of this is simply reflecting hesitation among businesses to boost capital spending until there is resolution on the China trade negotiations (and perhaps to a lesser extent on the final Brexit deal). Once such major issues are out of the way, the underlying fiscal stimuli should kick into higher gear, enticing companies to boost capital spending plans and increase guidance, thus fueling stronger growth in supply-side fashion. There are plenty of macro indicators that suggest the economy is still mid-cycle, including the significant contributions to GDP from nonresidential fixed investment and private inventory investment.

As for interest rates, there is another FOMC meeting coming up in March, so investors will be listening intently for any changes to the Fed’s language that recently transitioned from “autopilot” rate hikes and balance sheet reduction to patience, flexibility, and a commitment to data-dependence given the economic and political environment. Fed chair Jay Powell seems to have concluded that the fed funds rate is now essentially at the elusive “neutral rate,” and that it indeed matters to a heavily-indebted and inter-dependent global economy when US rates rise and liquidity is pulled out of the financial system. Inflation is still not a concern these days, as the BLS last reported CPI inflation of 1.6%, while the 5-year break-even for US TIPS is 1.85%. Moreover, given that wages and the labor force participation rate are finally starting to rise, and given that this helps address income inequality (which has become such a political hot-button), the Fed will be reluctant to do anything to change the direction of this dynamic. The CME Group fed funds futures are placing only a 6% probability of another rate hike by January 2020, and they actually show a 10% probability of at least one rate cut by then.

Thus, Treasury yields still haven’t moved this year. The 10-year US T-note closed Monday at 2.72% while the 2-year closed at 2.55%, so, the 2-10 spread is only 17 bps. If instead use the shorter-term 3-month T-bill at 2.46%, the spread versus the 10-year T-note is 26 bps. This flattening of the yield curve has caused concern among some analysts of a potential inversion, ultimately leading to a recession. But in my view, because such inversions historically have been caused by Fed rate hikes, this FOMC is going to be very cautious about playing any role in inverting the curve. So, with the Fed on the sidelines with respect to any further rate hikes, current rates look pretty good compared with other risk-free developed market 10-year yields, like France at +0.56%, Germany at +0.65%, and Japan at 0.00%. Even troubled Italy only pays 2.74%. Notably, ten years after the end of the Financial Crisis, $11 trillion in sovereign debt still trades at negative yields. 

Moreover, I still believe that the geopolitical risks coupled with the relative safety, stability and low inflation here at home will continue to maintain strength in the dollar and demand for US Treasuries by attracting foreign capital flows. There is rising demand for yield among the aging populations in developed markets and rising institutional portfolios (including pensions and superannuation funds), not to mention the large fixed-income mutual funds and ETFs whose mandate is to track the cap-weighted market indexes (i.e., they must buy Treasuries in their proportion to the broad fixed-income market). As a result, rising Treasury yields largely become self-limiting in that they ultimately attract a bid.

In addition, the Fed has signaled an end to quantitative tightening this year. After peaking in January 2015 at $4.5 trillion, the Fed’s balance sheet has shrunk to $4 trillion, so let's say it goes on hold at about $3.5 trillion. But as I pointed out back in 2017, there are some good reasons why the Fed may need to maintain a larger balance sheet than it has historically, such as increased foreign demand for U.S. dollars. The Fed itself estimated back in 2017 that the global economy likely would require dollar circulation to grow to $2.5 trillion over the ensuing decade. So, what’s another $1 trillion among friends?

I also have read opinions suggesting that international developed and emerging stock markets may outperform the US this year on a relative basis, citing that the MSCI All Country World (ACWI) ex-USA sports a P/E ratio 20% cheaper than the S&P 500. But I see this as yet another example of taking a single metric out of context. Regarding the MSCI ACWI, the largest sector exposure is Financial at 22%, with InfoTech at only 8%, while the S&P 500 has a 21% weighting in InfoTech and only 13% in Financial. Given that Financial is traditionally considered value-oriented with a lower P/E while InfoTech is traditionally growth-oriented with a higher P/E, it makes perfect sense that the more value-oriented MSCI ACWI index will display a much lower P/E. Thus, I do not think that this P/E gap is destined to close in a significant way (unless the global economy goes into a steep recession).

Comments on the February Baker’s Dozen portfolio:

As Sabrient’s February Baker’s Dozen passes its 1-year mark, let me take a moment to comment on the changing market conditions over the past year and their impact on portfolio performance. As you might expect given the strong economic climate and solid corporate earnings estimates, our growth-at-a-reasonable-price (GARP) model pointed us toward cyclicals and small-mid caps, which typically thrive when the economy is strong. But on 6/11/2018, the trade war with China escalated from rhetoric to reality, and when combined with increasingly hawkish Federal Reserve seemingly hellbent on raising rates and withdrawing liquidity from the financial system, the market embarked upon a fear-based risk-off rotation into defensive sectors (like Healthcare, Utilities, Consumer Staples, and Telecom) and mega-caps (including AAPL, AMZN, MSFT – the three largest holdings in the S&P 500), despite little change in the positive economic outlook.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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