The Road Ahead | First Quarter 2019

Peter A. Sorrentino, CFA

Eccles Federal Reserve Building

Thanks to a stable domestic economy, U.S. equity prices recovered the bulk of their losses from the closing months of 2018...

First Quarter 2019 Review
Thanks to a stable domestic economy, U.S. equity prices recovered the bulk of their losses from the closing months of 2018, advancing 17% from the start of the year to the March 21st peak. This was not unlike the episode from 1987, where equity prices plunged due to badly-distorted valuations, only to recover thanks to a strong economic backdrop. Just as during the period following the 1987 decline, we have experienced falling interest rates and rotation in market leadership. The defensive nature of 2018’s performance gave way in the first quarter to the appearance of procyclical leadership. Technology, industrial and energy shares led the U.S. stock market for the quarter. For technology, this was a continuation of the momentum theme that has propelled the group since the start of 2017. For the industrial, energy and materials sectors, the first quarter represented a repricing, as the groups had endured double-digit percentage declines as investors anticipated a turn down in economic activity. When a recession failed to materialize, these 2018 laggards rallied, bringing them back in line with the broad market. Continued improvement in employment and wages bolstered the consumer stocks, fueling their recovery by backstopping future revenue expectations. Shares of financial stocks fell out of favor with investors following the Federal Reserve Bank’s pivot to a more accommodative policy stance. While lower rates may spur borrowing, the downward pressure on interest rates is anticipated to narrow lending margins.

Exhibit 1 (Source: Bloomberg)

There was a performance bias during the opening weeks of the quarter to small and medium sized businesses. That began to fade as interest rates declined. By the end of the quarter, the performance differential had all but vanished as the Russell 2000® Index managed to just edge ahead of the Russell 1000® Index (14.18% to 13.43%). By the end of the quarter, the valuation level of the market had become virtually uniform regardless of company size. This illustrates the compression taking place as investors seek to maximize returns by exploiting perceived inefficiencies in the markets and moving money to capitalize on the perceived imbalances.

Exhibit 2 (Source: Bloomberg)

Bond markets did well during the quarter, thanks to the deceleration in real estate that helped offset the inflationary push of higher energy costs during the quarter, thus serving to keep current and future inflation expectations in check. Tame inflation, coupled with a moderating monetary policy stance from the Federal Reserve Bank, served to send interest rates on U.S. Treasury debt down. Illustrated in Exhibit 3, you can see the drop in rates from the high point on January 18th to the low point on March 27th. Bonds also enjoyed considerable demand from investors who had liquidated stock holdings during the last four months of 2018. The recovery of the major stock indices in the first quarter masked the fact that there was a substantial change in asset allocation following the 2018 decline, one favoring bonds over stocks. It was this demand that not only drove rates down, but served to, yet again, compress yields across the various types of credit instruments.

Exhibit 3 (Source: Bloomberg)

Corporate and municipal bonds performed well during the quarter as beneficiaries of the declining rate environment and dearth of new issuance. Scarcity drove demand with investors’ need for yield, serving to reverse the 2018 trend of widening credit spreads. Again, as visible in Exhibit 4, both corporate and municipal fixed income markets were beneficiaries of the need for stable income.

Exhibit 4 (Source: Bloomberg)

International markets recovered as well, but not having suffered as large a decline as those of U.S. stocks, the advances for both the developed and emerging markets were just above 9%. Here, one of the limiting factors was a persistently strong U.S. dollar. Declining U.S. imports and rising U.S. exports served to constrain the global supply of dollars, pushing the value up despite a deteriorating domestic fiscal deficit. U.S. energy exports continue to surge higher as witnessed by the U.S. surpassing OPEC in weekly export volume. With now four LNG terminals operational, U.S. LNG exports are becoming a factor in the world’s natural gas market. Crude oil, as measured by WTI, rose 32%, sending gasoline prices up by 42%, boosting the earnings of both domestic drillers and refiners.

Second Quarter Outlook
Our economic view holds that the U.S. economy slowed noticeably in the opening months of this year, and that slowdown will persist for the balance of the year. The recognition of this will likely induce renewed volatility in stock prices as investors recalibrate their forward expectations. We are seeing signs that the consumer is slowing down in terms of spending as witnessed by decelerating housing price appreciation and a persistent increase in the savings rate. This is not a complete surprise, as the length of this expansion and strong employment trends have served the consumer sectors well. Of growing concern for us is the direction of consumer spending. As the rise in the savings rate continues, we see signs of waning housing and auto demand. The recent drop in interest rates may serve to reverse these trends in the second quarter, boosting housing activity and, thus, supporting continued consumer spending growth. The tepid nature of inflation has limited pricing power among consumer companies and, with a tight employment market pushing wages and benefit costs higher, profitability for these companies is becoming increasingly problematic. Part of our economic outlook calls for reduced reliance on consumer spending and an increase in businesses outlays for this late-cycle economic climate.

We continue to see evidence of improved business spending and improved productivity growth, along with a lingering benefit to corporate America from last year’s change in tax regulations. There is a caveat to these last points: the grounding of the Boeing 737Max aircraft has the potential to create a domino effect, negatively impacting not only other aerospace companies, but airlines and travel companies as well. With this aircraft being the largest exporter in the U.S., a delay in aircraft deliveries will impact the nation’s balance of trade. Thanks to the recovery of energy prices, the outlook for companies engaged in the extractive industries continues to hold promise, in addition to supporting the demand for labor and, by extension, wages. The push for productivity, largely absent during the recovery so far, supports continued spending for automation as the tight labor market compels companies to employ capital in place of labor to profitably grow revenue. The mounting threats to personal and business data continue to drive spending on cybersecurity, adding to the demand for technology products and services. Interest rates will likely come under upward pressure in the second quarter, as issuers across the spectrum come to market with new issues, something we saw very little of in the first quarter. We are taking measures within the Comerica Preferred Portfolios to lock in recent gains in bond holding by both reducing interest rate exposure, through shortening the average portfolio duration, and taking credit risk down by shifting portfolios to the upper end of the quality spectrum.

Seasonal factors will also come into play as the second quarter unfolds. Historically, the flow of funds into the market from retirement plans and portfolio reallocations ebbs once we pass April 15th. There is a pattern of increased market volatility attributable to this. Combining this seasonal factor with our outlook for negative revisions in economic and earnings outlooks, it creates the potential to spike price volatility. As was the case during the most recent episode, any selloff in the market should be short-lived as the underlying economy, while slowing, continues to expand in a balanced fashion. We remain constructive on the financial markets with the anticipation of continued volatility. The market’s reliance on the momentum for leadership has pushed equity valuations to a level that, while not extreme, is at the upper end of the fair valuation range. Recent market action has illuminated some signposts for which to watch. As the yield on the ten-year U.S. Treasury note crosses the 3% level, the market has demonstrated a preference for value over growth and smaller capitalization over large. With our current interest rate outlook, we do not anticipate approaching that level in the immediate future and, as such, will stay the course with our current market strategy.


Second Quarter Asset Profile

For a PDF version of this publication, click here: 1Q2019_TheRoadAhead.

Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein have been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

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April 24, 2019
Peter A. Sorrentino, CFA, Senior Vice President and Chief Investment Officer of Comerica Asset Management Group

Peter A. Sorrentino, CFA

Senior Vice President and Chief Investment Officer, Comerica Asset Management Group

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