Eye on the Markets - 2019


Central Banks and Policies Guiding Economies

By Ketu Desai

The driving force behind the equity rally this year has been the policy shift among global central banks from restrictive to accommodative. During the month, we started to get evidence that the shift in policy is beginning to have an impact on the real economy. Starting with China, GDP estimates for the first quarter topped estimates, as did industrial production and retail sales. In the Eurozone, GDP surprised to the upside. Domestically, first quarter growth came in at 3.2 percent, considerably better than the below 1 percent expected earlier in the quarter. Further, leading economic indicators picked up in the most recent release, driven by strong labor markets, consumer confidence, and looser financial conditions. We also received strong durable-goods orders for March, indicating that business investment is picking up, which in turn could spark productivity and prolong the cycle. Lastly, with inflation under control, the recent data suggests we are in a goldilocks economy. In short, the combination of accommodative global central banks and the recent data have alleviated near-term recession fears for investors.

With the improved macro backdrop, cyclicals are leading the rally, which is a positive sign for the health of the rally. Cyclicals such as industrials, semiconductors, and financials have led, while, defensive sectors such as real estate and utilities have been sold. Healthcare stocks have also been aggressively sold in recent trading, with many names down more than 20 percent from their recent highs. Health insurers and healthcare service providers have been particularly hit hard. Investors fear drastic changes to the healthcare system and drug prices as we approach the election next year. Healthcare is the worst performing S&P sector, only up marginally, and is underperforming the S&P by nearly 15 percent year-to-date. While there appears to be opportunity in certain portions of healthcare, investors will likely have to withstand the ups and downs of an election cycle.

At the start of the earnings season, it was expected that earnings would decline 3-5 percent. The actual numbers have come in with earnings growth and with nearly 80 percent of companies beating earnings expectations. Revenue is up 5.1 percent. I think it is important not only that earnings are beating, but also the margin of beats (beating by 6.4 percent), the guidance, and the companies that are beating are important to the broader market and economy. We have had important beats from a wide range of companies including, JP Morgan, Bank of America, Constellation Brands, United Technologies, Johnson & Johnson, Coca-Cola, Honeywell, Apple, Netflix, Microsoft, Facebook, Visa, Lam Research, ServiceNow, McDonald's, Merck, Mastercard, Amazon, and Chevron. It is widely expected that the first quarter was going to be the worst of the year, and now with it behind us, investors are looking forward to the second half of 2019 and into 2020, when earnings are expected to accelerate. Earnings are expected to grow mid-single digits in the second half, and double-digits in 2020.

Despite the rally and improved backdrop for equity investing, money has not flowed into equities. In particular, approximately $10.5 billion has flowed out of equities, while $138 billion has flowed into fixed income. The 10-year yields 2.51 percent, while equity earnings yield more than double at 5.7 percent. If investors decide to reverse flows with the Fed on hold, stable inflation, record buybacks, marginally positive real rates, FOMO, and an improved economic and earnings outlook that could spark the next phase of the rally. After all, despite the strong S&P rally this year, we are only up 2.5 percent since the January 2018 high.

Looking forward, investors will continue to digest earnings and economic data, and follow the progress on trade negotiations.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com