Considering how low interest rates are relative to today's equity market...

Apr 2019
Julianna Donovan

U.S. equities ended the first quarter with the largest gain in nearly a decade lifted by the view that interest rates will stay low and a more optimistic outlook for global trade and economic growth. The S&P 500 Index increased by 13.6% (including dividends) in a broad recovery with all eleven sectors finishing higher. Investors returned to the market in the new year with views that stocks appeared oversold and that earnings and economic growth were likely to continue in 2019. Despite the large price move, the broad market indices remained just below the all-time highs reached last October. Stocks rebounded due to the Fed’s shifting outlook on interest rates for several reasons:

With interest rates remaining where they are, the economy should continue to grow (as we highlight above), providing a positive fundamental backdrop for corporate earnings.

Low borrowing costs are likely to continue to incentivize companies to issue low cost debt to fund acquisitions, buyback their shares and raise dividend payouts.

As bond yields fell in recent months, stocks appeared more attractive on a relative basis. Many dividend paying stocks now offer “equity income” that is on par or in some cases exceeds the yield on high-grade corporate bonds with the added benefit of growth in earnings and dividends. We expect this dynamic to support stocks in the months to come.

While monetary policy is important, there are two key factors which influence the direction of stock prices:

Earnings growth in S&P 500 stocks was extremely robust in the first three quarters of 2018, advancing 27% for each of the first two quarters and 32% for the third quarter. Growth was driven by a mix of top-line revenue growth, margin expansion, a lower corporate tax rate and contribution from share repurchases. In the fourth quarter, earnings growth slowed sharply, rising just 3%. Heading into the corporate earnings season for the first quarter, earnings are expected to be roughly “flat” versus a year ago. But it is important to recognize the difficult comparison versus a relatively high bar set one year ago. We see some potential for estimates to rise as the year progresses and expect to see modest growth in earnings in the low to mid-single digits. Moreover, we do not expect an earnings “recession” driven by weaker bottom line results.

Valuation is the second key factor. The S&P 500 ended the first quarter with a price multiple of 16.4x expected earnings for 2019. This level is in line with the 25 year historical average of 16.2x, but considering how low interest rates are relative to history today’s equity market valuation is quite reasonable.

International equities as an asset class in general have meaningfully underperformed U.S. equities over the last few years.

As a reminder, we choose to allocate a portion of client accounts to this asset class for diversification purposes and to realize compelling capital appreciation opportunities across the world. In light of these goals, during the first quarter of 2019 we conducted an in-depth review of our International Equity allocation as well as the specific securities we have chosen to garner this exposure. Our objective is to ensure we are achieving the desired asset class diversification and to make sure we are positioned to benefit from compelling long-term investment opportunities we see outside of the United States.

The key takeaways from this review are as follows:

  • First, our confidence in the long-term opportunity for emerging markets remains high, underpinned by the growth and spending power of emerging middle class consumer populations. We have focused our investment selection to express our conviction in this structural trend.
  • Second, we are still encouraged by the opportunities within developed markets outside of the U.S. that are valued inexpensively; we have positioned accounts to benefit from improving prospects for these markets.
  • Finally, we have built the core of the International Equity allocation around a broad, geographically diversified fund that will help to accomplish our objective in a highly effective and cost-efficient manner.
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