INTRODUCTION

Global markets enjoyed a strong start to the year, marking a steep reversal from the downdraft that maligned the fourth quarter. Weak or decelerating growth in virtually every major economy, coupled with lingering overhangs from international trade frictions, have compelled the major central banks to adopt stimulative policies for the foreseeable future. This is an enormous pivot, and indeed, much of the rally in the first quarter was fueled by this relief. We have maintained that a slower pace of rate hikes, ceteris paribus, would be relatively more favorable for asset valuations. Now, there may be no rate hikes at all.

MARKET UPDATE

After a period of exceptional market volatility during the fourth quarter of last year, the Federal Reserve signaled a reversal from their plans to keep raising interest rates. Beginning in January and despite a rate hike in just the previous month, Chairman Jerome Powell framed a cautious economic narrative citing sluggishness in Europe and Asia, ongoing global trade policy frictions, and mild domestic inflationary pressures.

Effectively, this new caution fomented a pivot by the Federal Reserve away from its prior course of monetary tightening. And with each passing month, Chairman Powell’s message on pausing U.S. rate hikes seemed to grow only more forceful. After meetings in both January and March, the Federal Reserve left the federal funds rate unchanged, in between a range of 2.25% and 2.5%. Furthermore, the Federal Reserve announced that it will slow the “run off” of its Treasury portfolio starting in May and will begin reinvesting bond maturities starting in October.

As market participants seized on this change, equity markets rallied, emerging market currencies strengthened, and long-term government bond yields and corporate credit spreads both fell. Within the equity asset class, this strength was universal. Returns from every sector and country in the global index were positive in the first quarter.

The U.S. economy remains relatively healthy when compared to the other major economies in the world, and it is a definite bright spot. Some recent data, however, appears mixed on the margin. Gross Domestic Product (GDP) growth during the fourth quarter was 2.2%. Capital investment by businesses and corporate earnings growth were strong, but monthly growth in consumer spending turned negative in December and failed to show a meaningful snapback in both January and February. It is possible that the recent consumer softness incorporated transient setbacks such as the U.S. government shutdown and unseasonably cold winter. More recently, both the Purchasing Managers’ Index (PMI) and spending on the services sector have decelerated meaningfully. Mild inflation is one of the factors that has informed the Federal Reserve’s new direction with its monetary policy. An economic environment with high employment and rising wages, as is currently found in the U.S., should be supportive of inflationary pressure, but inflation figures have remained below the Federal Reserve’s target of 2%. The Core Personal Consumption Expenditures (PCE) index, a measure of inflation that excludes food and energy prices, increased 1.94% in 2018 and only 1.79% in January.

In Europe, the economic slowdown in the region has accelerated. GDP grew 0.3% in the fourth quarter, the slowest pace of expansion in the last five years, and European Central Bank (ECB) President Mario Draghi made a fifth straight cut to growth forecasts. Much of this weakness is attributed to falling export demand and manufacturing activity, but even retail sales suffered one of the steepest monthly declines in the last decade this past December. Moreover, recent PMI data is not encouraging as economic activity in both Germany and France has contracted. Furthermore, Italy has slipped into a technical recession, afflicted by slowing global trade, weak consumer confidence, and pushback from the European Union (E.U.) to shrink its budget.

In response to the slowdown, the ECB also reversed its policy to favor economic stimulus. Recall that the ECB just ended quantitative easing in December. Now, President Draghi has pledged to keep the deposit facility rate, currently -0.4%, unchanged through the end of the year. Moreover, he announced that the ECB will restart a direct lending program to commercial banks, something that has not been offered since the Eurozone debt crisis. Under this program, banks will be able to access cheap, long-term loans directly from the ECB.

OUTLOOK

As we have previously stated, markets can move directionally opposite to economic fundamentals. During the first quarter, equity markets climbed, but the underlying economic data deteriorated.

Of all the major economic regions, the slowdown was most acute in Europe. The E.U. continues to face pressure from Brexit, slowing demand from China, and mounting debt in Italy. The ECB has already cut GDP growth forecasts twice this year, most recently to 1.1% in 2019. Meanwhile, recent PMI figures that show contracting economic activity hardly bode well for meeting the new full year target. Slowing global growth will be another headwind for the E.U., especially as the U.K. and China are top export markets after the U.S.