A strong quarter ends. Mixed signals ahead

Global stocks rallied by more than 12% in the first quarter in local currency terms, the best start to a year since 1991. As nerves calmed after a turbulent end to 2018, the VIX index of implied US stock volatility fell to around 14, below its average of 19 since the 1990s. Bonds rallied alongside stocks: The yield on the 10-year US Treasury fell 28 basis points to its lowest level since December 2017, and 10-year German bund yields dipped back into negative territory for the first time since 2016.

As the second quarter starts, investors are confronted with conflicting signals.

Equity markets appear to be pricing in several possible positive events including a successful outcome to the US-China trade talks, a recovery in global economic growth, and the Federal Reserve remaining on hold for the rest of the year. Bond markets, by contrast, are far less sanguine. The decline in 10-year US yields reflects pessimism over the growth and inflation outlook. For the first time since 2007, the yield on the 3-month Treasury bill rose above the 10-year yield in March. This phenomenon, known as a yield curve inversion, is generating a lot of headlines as a potential harbinger of recession. The risks highlighted by the bond market are real. But we believe there are grounds for confidence that the economic expansion and bull market can extend, rather than end.

We believe there are grounds for confidence that the economic expansion and bull market can extend, rather than end.

1. Lower bond yields could prove supportive of equity flows.

• The decline in yields makes stocks look more attractive by comparison. Despite the first quarter rally, the equity risk premium — a measure of the relative appeal of stocks and bonds — has only narrowed by 0.1 percentage points since the start of 2019. It is now 5.7%, versus a 30-year average of 3.3%. We believe concern over the recent inversion of the 3-month/10-year portion of the US yield curve is overblown.
• While it is true that inversions of the yield curve have historically preceded recessions, the lag is long and variable. Following the four such inversions since the 1970s the economic expansion lasted on average for a further 1.75 years, and stocks rose for another 1.6 years. Even more importantly, stocks rallied by 40.5% on average. And we see a similar pattern for inversions at the 2-year/10-year portion of the curve, which is currently still upward sloping. Since 1960, the S&P 500 has rallied an average of 15% in the 12 months before the 2y/10y spread hits zero, and 29% from the point that the curve inverts to the equity peak.

2. Economic growth should recover.

• While we want to see more signs of recovery before we increase our portfolio risk, there are reasons to believe the slowdown will be short-lived. The consumer side of the global economy is in good health — backed by global unemployment that is close to its lowest level in four decades. The recent economic weakness has been triggered, instead, by lower capital spending by businesses, which has curbed global trade. We believe this trend will reverse, especially if US–China trade talks produce even a partial resolution.
• Also, a significant part of the recent weakness in the developed market manufacturing sector stems from one-off problems in Germany, including tighter emissions standards in the auto sector. US growth has decelerated, but only back to trend levels of 2%–2.5%, as the benefits of tax cuts and higher government spending fade. China expects its economy to grow by 6%-6.5% this year, the slowest rate in decades. But the government is stimulating the economy through fiscal as well as monetary policy and we expect additional easing measures. China's manufacturing Purchasing Managers' Index, released on Sunday, showed the strongest rise since 2012 and is back above the 50 level that separates expansion from contraction.

3. Full-year US earnings growth should be positive.

• Investors have become accustomed to earnings expansion — with S&P 500 earnings per share growing by 23% in 2018 and by 12% annually on average over the past decade. Consensus is now for a 2% decline in EPS growth in the first quarter and a modest 1% increase in the second quarter. But we do not regard this as the start of a lasting contraction in profits.
• Historically, a reading of greater than 50 on the ISM survey of manufacturers leads to positive earnings growth six months later: the reading for February was 54.2. For 2019 as a whole, we expect earnings growth of around 4%. The slowdown in headline earnings is also exaggerated by a fading boost from US tax reform and idiosyncratic headwinds in a handful of sectors.

The risks to the outlook are real, and we recently reduced our equity exposure. But the case for optimism persists, and so overall we remain modestly risk-on in our tactical asset allocation.

Bottom line

A strong first quarter for investors has drawn to a close. Global stocks rallied by more than 12% in local currency terms, the best start to a year since 1991, and bonds rallied too. While the second quarter is starting with conflicting signals, we believe there are grounds for cautious optimism on the outlook for the global economy and markets.

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