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Market Outlook - May 2019

Economy

While the 3.2 percent growth rate captured in first quarter GDP surprised economic commentators, a closer look at the strengths from the report suggest the economy will cool from above-trend expansion to trend growth (approaching 2 percent) by the end of 2019. First quarter results were the best since 2015 as GDP growth benefitted from increased inventory levels (tend to normalize over time) and improvements in foreign trade (considered a more volatile component). Growth in final sales to domestic purchases emerged as a weakness from first quarter GDP falling to 1.4 percent, recently peaking in the 2nd quarter of 2018 at 4.0 percent.

On May 3rd, the White House increased tariff rates for $200B in Chinese goods with President Trump suggesting a willingness to expand tariffs to all goods imported from China. In response, Chinese officials, while giving a vague promise of retaliation, made no indication of stalling talks with the U.S. in mid-May. Despite heavy coverage of the ongoing dispute between the U.S. and China, research provided by the Bank for International Settlements (BIS) demonstrates a trend of declining global trade since 2011, a by-product of the global financial crisis. The paper highlights the impact of declining access to credit required by multinational firms to sustain global supply chains (In 2014, study found 35 percent of trade dependent on the banking system; 80 percent of which was financed in U.S. dollars). The tightening financial conditions which followed made global chains less attractive economically, befitting the rationale behind more domestic/regional trade networks.    

Equity markets

During April, large cap companies (S&P 500) returned 4 percent, outpacing Japanese and emerging equity markets which rose 2.0 percent and 2.6 percent, respectively. Through the first 4 months of the year, the S&P 500 has added 18.2 percent. Catalysts for last month’s rally included surprise earning results during the first quarter from U.S. companies. Also, an increased willingness by Federal Reserve officials to delay further tightening which depends on a significant trend in higher inflation, rather than temporary overshoot of the Fed’s 2 percent target level. View of an ease in the stand of the Fed led to an outperformance for economically sensitive companies versus shares of more defensive companies.

Data received from FactSet covering first quarter corporate earnings, shown through early May, show earnings declined by 0.5 percent year-over-year. The update reflects earnings results for 90 percent of companies comprising the S&P 500. While reported earnings results have come in less severe than forecast (-4 percent expected), the first quarter is on pace to end as the first quarterly earnings decline since the 2nd quarter of 2016. The prior run-up in stock prices since late December has pressured valuation multiples as the forward-looking price-to-earnings ratio (P/E) has moved to 16.5, above the 10-year average of 14.7.

Fixed income markets

The recent escalation of the U.S.and China trade dispute has led to a flight to quality in global fixed income, as U.S. Treasuries, agencies and German bunds out-performed, while most corporate credit and high yield issues saw spread widening. The yield on the 10-year Treasury fell to 2.35 percent, close to its 52-week low.  The trade war could drag on for months, with some meaningful impact to GDP (possibly lower by 0.2 percent to 0.3 percent, starting in the second quarter) and also an increase in headline inflation (CPI may move higher as tariffs are passed on to consumer by way of higher prices). Within the U.S. government markets, U.S. Treasury Inflation-Protected Securities (TIPS) may offer good value, given the expectation of increased inflation. In addition, agency debt (Federal Home Loan, Federal Farm Credit) and FDIC insured CD’s may also out-perform, as these security yields have not fallen at the same pace as U.S. Treasuries, and the obligations remain full faith and credit of the U.S. government. 

Spreads on corporate bonds moved wider by 5 basis points, (0.05 percent) while high yield spreads moved wider by 25 basis points (0.25 percent) in the last week. The moves seem relatively small, as the timing of the trade resolution may still be early – a protracted dispute could lead to more widening.  A move up in quality is not as attractive as a month ago, however, the risk seems somewhat asymmetrical with the possibility that corporate bond spreads will move much wider with a prolonged dispute and increased uncertainty. Consumer credit, specifically MBS may provide a stable safe-haven, with the sector’s option-adjusted spreads of 75 basis points, and virtually no credit risk. Municipal bonds may also out-perform, despite tight spreads compared to Treasuries. (yields are near 78 percent of similar maturity Treasury rates, near the lowest level in the last 52 weeks).  Issuance is expected to remain muted, given improved balance sheets of municipal issuers.  In addition, higher tax rates in years to come (expected by some) would not have an impact on federally tax-exempt municipal bonds. 

Alternatives/Real assets

Global oil prices, measured in Brent crude, rose $5/barrel since March to $71/barrel back to the average price for 2018. The Energy Information Administration (EIA) forecast average oil prices of $70/b in 2019 and $67/b. Global supply has been influenced by increased production from Saudi Arabia, the UAE, Kuwait and Russia to offset sanctions for Iran and Venezuela.

Prequin, a data provider for alternative investments, surveyed 400 institutional investors seeking the primary objectives investor’s shared relating to various asset classes. Those seeking to add diversification and low correlation gravitated towards hedge funds and natural resources. Those focused on achieving high absolute and risk-adjusted returns increased weights to private equity funds. Private equity investors highlighted increasing valuations as the leading challenge to future returns, but their concern does not appear to impact future allocation decisions as only 5 percent plan to reduce capital allocations to the sector.

Securities offered through Rehmann Financial Network, LLC, member FINRA/SIPC. Investment advisory services offered through Rehmann Financial, a Registered Investment Advisor. 1500 W Big Beaver, Troy, Mi 48084 | 248.952.5000.

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