First Quarter 2019 Market Update
Equity markets have come a long way off the market lows of 2009, and investors have endured numerous nerve testing drawdowns along the way. But this past December’s downturn brought back some memories of 2009 and just how painful it was back then for clients, investors, and colleagues.
One of my most vivid memories of the 2008 financial crisis and the impact it was having on people’s lives and future plans came on a visit to M&T Bank’s headquarters in Buffalo at One M&T Plaza on a cold day in March 2009. On my way to a meeting on the 7th floor I ran into one of our managers who had been employed with the bank a long time. Mark (name changed here) had accumulated a sizeable amount of bank stock and saved diligently in his 401-k over the years.
Only days away from the all-time low on the S&P 500 of 666, the markets were in a meltdown and the mood on the 7th floor trading area was somber and tense. Mark had been planning on retiring within the next 12 months, and our conversation went from catching up on family to his realization that this downturn had just extended his retirement plans. There was no levity or joking around his comments. He went from a one-year glidepath to at least another five years on the fast track. Of course, the markets came back and, in the end, everything worked out fine for him as he had the patience, the time, and the human capital to continue to work and wait out the recovery.
Had Mark reacted with his emotions and sold out of the market only a week away from the very bottom, his retirement plans would have been extended much longer than five years.
This past December’s volatility again tested investor resolve to hold steadfast to their financial plans. And as we look back on what was one of the worst months in market history, we have just closed out one of the best first quarters in recent market history.
A quick reversal in sentiment came in the first quarter of this year as the Federal Reserve reversed course on any notion of raising interest rates in 2019. The Russell 3000 came roaring back, posting a return of 14.04% for the 3 months ending 2019. U.S. equities outshone global markets, with small-cap and mid-cap companies leading the way. International equities also had a solid quarter, yet they continued to lag most all U.S. market indices. Even the U.S bond market managed to post an impressive quarter of nearly 3% as lower interest rates raised bond prices.
Stocks continued to rise into the second quarter, as positive overseas and domestic data injected some calm into the markets and helped move major indices within a few percent of record highs. China provided the initial catalyst, after releasing a purchasing manager’s index (PMI) showing a return to growth in the manufacturing sector after a six-month streak of contraction. Apparent progress in US-China trade talks also added to the buoyant mood this week, though obstacles to completing a deal remain.
Economic & Market Outlook
Predications and The Yield Curve—Is it really that foretelling?
Wall Street bond managers have historically been deemed in control of the “smart money” that moves through the markets. Beyond the pure bond math that dictates bond prices during rising or declining rate cycles, credit markets offer much information to equity investors in terms of credit spreads as well as where bond buyers park their money along the yield curve. Historically there has been much predictive power in fixed income markets, and the “smart money” that shapes the yield curve has offered valuable information.
Much of this information remains distorted today due to capital sloshing around the globe in search of lower yields as the credit supercycle continues—yet still much can be gleaned from the curve.
Currently, it may be signaling several different paths for the economy and inflation; one where inflation remains low or continues to decline in the context of a healthy economy; the other where inflation declines in the context of a declining economy. History has shown that inverted yield curves have preceded every post-war recession with a lead time of about 12 to 18 months from the first sign of inversion. Bond investors look to be signaling that a policy response is needed to extend the current economic cycle. How the Federal Reserve responds over the next 6 to 9 months will likely dictate whether we enter what we think would be a mild recession in 2020 or 2021. At present, we believe we are in a low inflation environment with a healthy economy.
So, for now we believe that a slight inversion does not offer very much predictive power. Distortions around sloshing global liquidity in search of higher yields make it a murky indicator at best over the very short term. A prolonged inversion is a different story, where credit demand would weaken, affecting the banking sector, the consumer, and ultimately the economy and earnings growth.
Since 1978, when the two-year Treasury note yield rose above the 10-year T-Note yield—a worrisome inversion—the S&P 500 Index has kept on rising on average for the following 19 months, with an average return of 22%. So, we keep watching, but in the meantime our eyes turn to corporate earnings and the resolution of the trade war with China.
The chart below illustrates the predictive power of the yield curve—or lack of when the inversion takes place many quarters ahead of the downturn. We have some time.
Stock Market Outlook
First quarter earnings revisions have been in steady decline since January. Earnings downgrades are now easing, with Bank of America’s recent estimate revision ratio now advancing for the first time in six-months this March. All eyes will be on first quarter earnings which are expected to decline by -3.9%, marking the first year-over-year decline in earnings for the S&P 500 Index since Q2 2016—our most recent “earnings recession”. Still, expected earnings growth remains at about 5% for 2019, which would put S&P 500 earnings at $170, which equates to a price to earnings ratio of around 16.3-above the ten-year average of 14.7, but below the five-year average of 16.4.
Our wall of worry today includes China trade talks, Federal Reserve Policy, Slowing Corporate Earnings and the inverted yield curve. Investors are compensated for staying steadfast in the face of these risks—that is what the equity risk premium earned over risk free treasury bonds is all about. Yet we also know that a misstep in any one of these bricks in the wall of worry can bring on the next recession.
Outside the US, the global economy remains fragile and growth has been slowing from 3.5% to the latest IMF forecast of 3.1%. Yet recent data do provide some hope that a stabilization in growth may be occurring. In addition to the China PMI number mentioned above, the solid March US jobs report, as well as better industrial production numbers from Germany all indicate that global growth may be stabilizing. Taken together in a context of continued easy monetary policy that was affirmed this week with Mario Draghi’s comments as well as a low CPI inflation number in the US, the global economy can continue to move forward, provided we get a resolution to the US China trade talks.
As attention now turns to earnings season, we always listen in on bank earnings calls to gain some insight into the health of the economy and the outlook and guidance given by these institutions which are embedded in every aspect of our economy. We have always considered them the canary in the coal mine when it comes to guidance on the health of the consumer and business lending. This morning we heard from JP Morgan’s CEO Jamie Dimon, who stated that “financial markets are healthy, and consumer and business confidence remains strong.”
With earnings season off to a good start, low inflation, and the Fed on hold, we really see no recession indicators other than the blip in the inversion of the yield curve-explained above. Also, the tax cuts enjoyed by many companies in 2018 will continue to be a positive to those companies that wisely allocate their capital. Much of the media talk on the tax cuts paint this windfall as a one-time event, but for those companies that benefited from the lower rates, their free-cash flow stream will continue to be higher because of the reduced tax expense. How they allocate that new cash flow will be key, and we believe that the smaller and mid-size companies will benefit disproportionately from the tax cuts—but overall a clear positive for corporate earnings going forward.
Timing the markets has always been a foolish approach to investing, and a sure way for investors to miss out on capturing the longterm equity risk premium. Rebalancing back to investment policy is the smart way to trim risk as markets rise and increase risk as markets swoon.
Not all investors have the assets needed to employ strategies that work over “infinite” time horizons, and as we have mentioned numerous times before, it is cold comfort to be told that the long term will take care of everything—especially in times like the Spring of 2009. That is why it is important to continue to update your investment policy to your current stage in life and make appropriate changes, model those changes and stress test them for some ugly markets. Equity investing is truly for the long term, and the key is to have a policy that allows for the equity allocation of your portfolio to endure volatile markets while still supplying the needed cash flow to sustain your retirement lifestyle.
John Klobusicky, CFA, CAIA
The Long-Term Benefits of Roth IRAS
The Roth IRA is a tax-efficient option for retirement savings.Earnings in a Roth grow tax deferred, and distributions are tax free, provided you have reached age 59 ½ and have owned the account for at least five years. What many may not realize is that the Roth IRA offers another key, long-term benefit.
Unlike traditional Individual Retirement Accounts (IRAs) that have mandatory minimum distribution rules when the IRA owner reaches age 70 ½, the Roth IRA does not require mandatory minimum withdrawals for the Roth owner. Therefore, the Roth owner can continue to fully reap the benefits of tax-free accumulation well into his or her retirement years while retaining the ability to take withdrawals only when necessary. In addition, a Roth owner can continue making contributions after age 70 ½ , provided the owner earns taxable compensation and his or her income is within the specified limit.
Bear in mind that eligibility for a Roth IRA begins to phase out when adjusted gross income (AGI) exceeds $122,000 for single taxpayers and $193,000 for married taxpayers filing jointly (complete phase out occurs when AGI exceeds $137,000 for single taxpayers and $203,000 for married taxpayers filing jointly).
Stretching IRA Withdrawals
The primary concern of some traditional Individual Retirement Account (IRA) holders who are approaching the mandatory distribution age (April 1 of the year after the year they reach age 70 ½ ) may be stretching their account assets over their lifetime and that of their spouse. Maximizing tax deferral and/or passing these assets to their heirs may be of lesser importance.
Regulation reform finalized in 2002 makes this task much easier. In response to Americans living longer, healthier lives, the Internal Revenue Service (IRS) increased the life expectancy figures on which required minimum distributions (RMDs) are based. As a result, RMD amounts have decreased, and IRA owners are now allowed to withdraw less than was necessary under the original distribution rules. For most, RMDs are calculated using a uniform table (uniform lifetime table), which assumes a beneficiary is fewer than ten years younger than the owner, regardless of the beneficiary’s actual age.
If the IRA owner has named his or her spouse as the sole beneficiary, and the spouse is ten or more years younger than the owner, a second table (joint life and last survivor expectancy table) may be used to calculate the RMD.
Married individuals quite often name a spouse as the beneficiary of an IRA. If the IRA owner dies prior to, or after, the mandatory minimum withdrawal date, only a surviving spouse can choose to make an inherited IRA his or her own. This would postpone mandatory distributions until April 1 of the year after the year in which he or she reaches age 70 ½.
In contrast, a non-spousal beneficiary is more limited and must begin taking distributions from an inherited IRA by the end of the year following the year of the owner’s death. With the legislative changes, however, the consequences of beneficiary choices are no longer dependent on whether the IRA owner died before or after starting the required withdrawals, simplifying planning decisions. Unlike the old rules, such distributions no longer must continue to be based on the owner’s original life expectancy calculation, but may now be stretched out over the life expectancy of the beneficiary, significantly extending the potential benefits of tax deferral.
What’s the Advantage?
These simplified rules should make it easier for some retirees to meet the minimum distribution requirements, thereby avoiding unnecessary penalties, while enabling the greatest possible buildup of their tax-deferred assets. However, IRA owners should be aware that any such buildup could potentially lead to higher estate taxes down the road. If you have an IRA and have reached (or are approaching) age 70 ½, it may be best to consult a qualified tax and financial professional for assistance with your particular circumstances.
We encourage you to meet with us to review your portfolio and financial plan.
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