Springing Higher Into 2Q
April 2019
The global economy has experienced a notable slowdown over the past couple of quarters; however, policy responses abroad aimed at stimulating growth have been swift and are already bearing fruit. Specifically, recent manufacturing data out of China flipped back to signaling expansion in March for the first time since November. The Federal Open Market Committee (FOMC) has fallen in-line with the European Central Bank (ECB) by taking on a dovish posture, and the futures market is now pricing in a greater than 60% chance of a cut in the Fed funds rate by September. The old adage “don’t fight the Fed” immediately comes to mind, and continued accommodative global central bank policies, whether you agree with the rationale behind them or not, are undeniably a near-term tailwind for equities.
As positive catalysts go, investor positioning is at the top of our list. As the yield curve flattened and ultimately briefly inverted between 3-month and 10-year instruments, investors jettisoned equities as pundits were quick to begin winding the countdown clock leading up to the next recession. Both the exodus from stocks and the recession countdown appear to be premature, and the contrarian in us views this as a positive sign for further, potentially significant upside in equities. In the face of continued net outflows from equity mutual funds and hedge funds taking down net exposure to stocks and reducing leverage, the S&P 500 still managed to rally 13% in 1Q19. If hedge fund leverage ticks up even slightly and retail investors creep back in alongside corporate buybacks, which will resume after the standard blackout period leading up to earnings, the rally may yet have much further to go.
Interestingly, despite continued caution on the part of retail and select institutional investors, the S&P 500 managed to form a bullish golden cross chart pattern as we exited the first quarter as the shorter-term 50-day moving average crossed above the longer-term 200-day moving. Many fund managers held excess cash for potential redemptions or carried overweight allocations to select defensive sectors during the first quarter rally and are already behind the 8-ball, underperforming their benchmark. Retail investors hiding out in cash and Treasury bonds are developing or are in the midst of full-on FOMO - the fear of missing out - as stocks march higher despite a flurry of erratic economic data. Both groups face an internal struggle - put cash to work now, or wait for a near-term pullback that may or may not come.
The first quarter was a great reminder that stocks aren’t the economy as stocks rallied in spite of an onslaught of lackluster or downright disheartening economic data. Monitoring economic data and trends will always be a key cog in our asset allocation process, but Mr. Market’s interpretation of and reaction to data can be very different than what you or I might view as reasonable, that’s what makes a market. With global central banks on the sidelines and policy normalization less of a hindrance to growth, the global economic slowdown in progress could reverse course rather quickly should business confidence rise on the heels of a U.S./China trade resolution. Sector leadership and market breadth has been encouraging as consumer discretionary, energy, information technology, and industrials all outpaced the S&P 500 during 1Q. One glaringly obvious underperformer in the year-to-date rally has been the financial services sector, but long-term interest rates bottoming and reversing course higher could generate increased buying interest as expectations have been drastically lowered in recent months. We remain constructive on equities, specifically U.S. large-cap and emerging markets, while we are less optimistic on international-developed markets, specifically Europe, as Brexit uncertainty persists. Spring is finally here, and economic green shoots are appearing abroad, a potential catalyst for the next leg higher in equities.
Source: Bloomberg, Factset, IHS Markit
