31 Mar Q2 2019 Economic Update
Since our last update, we have seen what we believe to be two key movers in the market have made significant changes: the FOMC has decided to halt raising rates and progress towards a trade agreement with China has significantly strengthened. The result has translated into the S&P 500 having its best quarter since the tech bubble in 1998, with an incredible return of 13.65% for the first quarter of 2019 (Factset Return Data). However, GDP grew at a modest 2.2%, year over year, in the fourth quarter (Factset Economics Data). The stark contrast between what the market is pricing in and how the economy has been growing is an interesting one. Of course, the stock market is a leading indicator of economic expectation; whereas, quarterly GDP is a lagging indicator of the economy. We believe that investors seem to believe that the economic growth is going to be more prosperous than the 4th quarter GDP growth rate indicated.
Let’s begin by dissecting the ongoing china trade negotiations. In general, bilateral and multilateral trade agreements are quite rare, especially between the two largest economies in the world. Much has been made about the harm a trade war can cause on an economy, but what has not been examined as much is the great economic benefit from a mutual trade agreement. In fact, this would be the largest bilateral trade agreement by the U.S. in over 30 years, when the U.S. and Canada struck an agreement in January 1988 (Reference For Business). Below is a chart illustrating the return of the S&P 500 index in the calendar year following the enactment of the agreement:
While the S&P 500 has already exceeded that mark in the first quarter alone, it has done so without robust GDP growth, as quantified by historical basis. For example, below is an example illustrating the year over year GDP growth of the U.S. by the end of the calendar year following the enactment of the agreement:
This marked nearly a 20% increase in the economic growth rate from the point prior to the agreement. This runs in parallel with total exports to Canada increasing by roughly 18%, from roughly $60 billion for the entire calendar year in 1987 to nearly $72 billion for the entire calendar year in 1988.
As a result of the economic growth, the S&P 500 continued to grow at a cumulative rate of 43.60% over the 3-year period following the agreement:
The agreement with Canada was then expanded in January 1994 to include Mexico in a multilateral trade agreement known as the North American Free Trade Agreement (“NAFTA”) (Office of the U.S. Trade Representative). This agreement enabled exports from the U.S. to each country to triple over the years.
As it stands right now, the U.S. exports more than twice as much to each Canada and Mexico than it does to China, yet China’s economy is nearly 6 times the size of both Canada and Mexico combined (Factset Economics Data). We believe a trade agreement with the world’s second largest economy should have an even larger economic impact than the trade agreements with Canada and Mexico. While it appears that the market has been pricing in a trade agreement with China, it’s difficult for the market to quantify exactly what that impact will be without knowing the details of the actual agreement. If historical precedence is any indicator, we believe the market has not fully priced in its economic impact.
Meanwhile, the Federal Open Market Committee (“FOMC”) has caused a lot of disruption within the credit market. Since the current chairman, Jerome Powell, assumed the role back in February 2018, the FOMC has raised the federal funds rate nearly one full percentage point to get ahead of potential inflation in the economy (Factset Economics Data). The FOMC maintained that their target inflation rate was around 2.2%, which happened to be what inflation was at the time Jerome Powell took office in February. Inflation rose modestly, but never really rose much above 2.6% (Factset Economics Data). Despite that, the FOMC enforced an aggressive policy to raise rates. However, it has seemed that they overshot their mandate. The result has been a sharp decline in inflation and an inversion on the short end of the yield curve:
The recent FOMC minutes from their March 19-20 meeting suggests a pause in hiking rates further. Some members even intimated that the FOMC could potentially provide a more accommodative policy should recession fears persist. The futures market is currently pricing no rate increase this year, and a 55% chance that the FOMC will cut rates by the end of the year (CBOE futures market). Given that the FOMC has steered more dovish, we believe that this has allowed the market to shed fears of a liquidity crunch in both the bond and stock market. Should the FOMC cut rates at all, this could theoretically create more liquidity and more certainty in the market, which we believe is not being priced into the market.
The bottom line is that, despite an excellent first quarter, we believe the market has room to grow, given these two potential tailwinds. Of course, the details of how it plays out will be critical, but we believe it is crucial to focus on the fundamentals right now as we believe there are several opportunities where companies are currently undervalued.