- It appears that while U.S. economic growth has slowed, we are not yet close to a recession.
- The predictive value of the yield curve is dependent on the duration of the inversion, and it remains important to not overreact while diligently monitoring its status going forward.
- The stock market is at the upper end of its valuation range and most of the opportunities we see are repositioning moves to prepare the portfolio for the later stages of a business cycle.
Market Overview and Outlook
In the first three months of 2019 the stock market generated a total return of 13.6%, its strongest quarter in almost 10 years. High-yield spreads narrowed by more than 100 basis points and oil prices rose from the upper $40s to the low $60s. The U.S. dollar rose 2.5% to approach 18-month highs while the U.S. 10-year Treasury yield fell from almost 2.70% to 2.40%. At quarter end, the U.S. Treasury yield curve (as measured by 3-month notes and 10-year bills) hovered around flat after a brief inversion in the preceding week. German 10-year yields turned negative once again.
Stock market internals echoed the divergent moves in financial markets. Stock market breadth was outstanding during January but narrowed in February and March. The strongest sectors — technology, industrials and energy — were among the weakest sectors during the fourth quarter of 2018. Health care lagged in the first quarter as the government continued its effort to reduce drug prices. Financial services companies also trailed the broader market owing to the flattening of the yield curve. Lastly, concerns about international growth hurt materials performance relative to the market.
The positive news underlying the equity market rally was the U.S. Federal Reserve’s pivot away from further interest rate increases, with March’s “dot plot” suggesting no planned rate hikes in 2019. The markets were also pleased that the U.S. and China seem headed for resolution of their trade dispute.
Worldwide economic weakness, especially in manufacturing, drove the strong U.S. dollar and significant declines in sovereign bond yields. European economies were especially soft as evidenced by an Italian recession, sustained UK Brexit-induced disruption and a weak German PMI in late March (which indicated shrinking manufacturing output). Also, while European banks have improved their capital levels, they are still perceived to lag U.S. counterparts and remain fragile. As an example, Deutsche Bank may be forced to merge with a stronger partner.
The industrial side of the economy showed widespread weakness in the first quarter, hurt by headwinds from the U.S. government shutdown, weather, the strong U.S. dollar and Chinese trade war fears. Durable goods slowed to stall speed, just about 0%. In March we saw the weakest ISM Services PMI since August 2017 at 56.1, suggesting slowing — albeit still positive — growth. One area of concern to us is that short-cycle companies we follow — those whose sales respond quickest to near-term economic conditions such as 3M — saw a deceleration in March.
The consumer side of the economy was much better than the industrial side. The auto SAAR bounced to a strong 17.4 million in March after 16.8 million readings in January and February. Early indicators of March housing sales look good as it appears the U.S. consumer is responding positively to lower interest rates. Perhaps most important, employment remains robust. Unemployment claims of 202,000, as reported for the week ended March 30, were the lowest in 49 years. On balance, it appears that while U.S. economic growth has slowed, we are not yet close to a recession. First-quarter 2019 GDP growth looks like it came in at about 1.7%.
An inverted yield curve is one of the best indicators of an incipient recession, although it is not perfect. Seven of the last 10 recessions were preceded by 10-year Treasury yields below 3-month treasury bonds. While the financial press has made a lot of noise about the inversion, the predictive value of this indicator is also dependent on the duration of the inversion. Therefore, it remains important to not overreact while diligently monitoring its status going forward.
The stock market is at the upper end of its valuation range and most of the opportunities that we see right now are repositioning moves to prepare the portfolio for the later stages of a business cycle. For example, property and casualty insurance companies are very defensive in a recession, while banks suffer from a flat or inverted yield curve. The hit specialty chemicals and paint companies take from weaker volumes is overwhelmed by the earnings improvement from lower raw materials prices. That said, there may be some opportunities in technology as new 5G telecommunication standards appear to be coming “online” faster than expected — equipment and tower companies may be attractive plays on this trend. The public cloud companies continue to grow rapidly, driven by the paradigm shift in software to agile designs that run on the cloud, thus enabling semiconductor capital equipment companies to benefit from demand growth.
"A U.S. recession in the near term seems unlikely
given a robust U.S. consumer."
A U.S. recession in the near term seems unlikely given a robust U.S. consumer. That said, international economies are fragile and the typical excesses that build during an economic recovery are starting to appear. If we were to witness a sustained rebound in Europe and easy credit were to accelerate growth in China, company earnings could surprise to the upside in the second half of 2019 and drive further market gains. The Appreciation strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy continues to grow and preserving capital should a shock appear that causes a market downturn or an economic recession.
The ClearBridge Appreciation Strategy had a positive return during the first quarter of 2019, underperforming the Strategy’s S&P 500 Index benchmark.
On an absolute basis, the Strategy had gains in all 11 of the sectors in which it was invested during the quarter. The main contributors to the Strategy’s performance were the information technology (IT), communication services and industrials sectors. The utilities and real estate sectors contributed the least.
In relative terms, the Strategy underperformed its benchmark impacted by stock selection and sector allocation. In particular, stock selection in the financials, health care and communication services sectors detracted the most from relative performance. The Strategy’s cash position also detracted. Conversely, stock selection in the materials sector contributed positively.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Microsoft, Comcast, Apple, Visa and Honeywell. The greatest detractors from absolute returns were positions in CME Group, CVS, Berkshire Hathaway, Bristol-Myers Squibb and Pfizer.
During the quarter, we established a position in American International Group, in the financials sector. We closed positions in Bristol-Myers Squibb in the health care sector and Kimberly-Clark in the consumer staples sector.