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Quarter 1

1/31/2019

 

The market began the year on a positive note with the S&P 500 index increasing 13%, regaining a good portion of what was lost in the final quarter of last year. In fact, January and February combined to generate the best two-month start to a year since 1991.  Of course we would be remiss if we didn’t also point out that December of last year was one of the worst months for market performance since 1931.  The bottom line is that volatility has returned to the market and we probably will just need to get used to it.

What exactly is generating this elevated level of market volatility? Currently there is a high degree of uncertainty regarding the future growth rate for the U.S. economy.  Several economic indicators have receded over the past few months and some investors are speculating that the economy may drift toward recession later this year.  It should be noted however that we have seen this very same seasonal data pattern before, where economic activity in the first quarter of the year starts out slow, but then gains strength over the balance of the year.  This year also happened to be weighed down by a partial government shutdown (political gamesmanship) in January and a major trade dispute with China that is currently hampering both exports and imports.  Assuming that a trade resolution with China occurs sometime over the next several months, there is good reason to expect that economic activity will once again begin to perk up as we head into summer.

The Federal Reserve has direct control over short-term interest rates. Unfortunately, it has been difficult to diagnose their thought process lately.  Just last fall the Fed was adamant about raising short-term interest rates by at least another full percentage point in 2019.  Then in December last year the Fed cut in half its projected rate increase for 2019.  Finally, just last month the Fed announced that there would be no rate increases at all this year.  Apparently the Fed has taken notice of the slower economic activity occurring in both Europe and Asia.  Afraid that this global slowdown could spill over to the U.S., the Fed has chosen to err on the side of caution.  As a result both short and long-term interest rates have declined since the beginning of the year, with long rates falling more than short rates.  The 10-year Treasury bond yield has fallen by more than half a percent since January, and now currently stands at 2.40%.

Falling interest rates should support higher price/earnings multiples for stocks. Conversely, there is also a higher likelihood that we will see earnings estimates revised downward for many companies when first quarter earnings reports are issued in the coming weeks.  These cross-currents may cause the market to tread water for a while until there is clear evidence that the economy is either expanding or contracting.  A trade resolution with China could provide the spark the economy needs to lift higher.  Investors will likely respond favorably to a trade agreement, particularly since bond yields have fallen to a level that no longer represents a good alternative investment.  In the meantime, patience is the best advice.