Investors cheered as the Fed turned dovish. Stocks enjoyed a vigorous turnaround in the first quarter after enduring painful performance and sinking sentiment in last year’s fourth quarter. Fed chairman Jerome Powell pivoted from endorsing further interest-rate hikes in December to proclaiming “patience” in January as the Fed’s new guiding principle for monetary policy.
- Following the March 20 FOMC meeting, Powell not only announced that there would probably be no rate hikes this year, but also said that a rate cut wasn’t out of the question.
- And there was more: The Fed declared that it would end its quantitative tightening program in September.
For stocks, the best first quarter since 1998. In a lower-for-longer environment, stocks looked more attractive and, indeed, performed well across the capitalization spectrum.
- The S&P 500 rose 13.6%, its strongest first quarter since 1998.
- Small caps posted their best first-quarter return since 1991, with the Russell 2000 Index up 14.6%.
- Mid caps outperformed large caps and small caps.
- Growth outperformed value in all cap ranges.
Bonds rallied on Fed news and weak global growth. Bonds nearly doubled their fourth-quarter gain even in such a risk-on environment, as investors hailed the Fed’s dovishness and took the weak global growth picture as a signal that rates weren’t going up anytime soon.
- The 10-year Treasury yield closed at 2.40%, down 28 basis points during the quarter.
- The high-quality Bloomberg Barclays US Aggregate Bond Index gained 2.9%, while the Bloomberg Barclays US Corporate High-Yield Bond Index surged 7.3%.
Strength in underlying equities boosted convertible returns. Convertibles moved directionally with equities and outperformed bonds (both investment-grade and high yield). The Thomson Reuters All Cap Focus Convertible Index gained 11.2%.
Our strategies generated strong gains (see page 3 of the pdf). With their small- and mid-cap growth tilts, all of our strategy composites produced positive absolute returns and most outperformed their benchmarks for the quarter. Healthcare (driven by M&A activity in biotech) and technology (a surge among our software and semiconductor holdings) positions were among the biggest contributors to absolute returns across our portfolios.
A constructive environment. On balance, we see a constructive environment for equities. Following the fourth quarter, we felt that three factors—US trade with China, interest rates and confidence—held the key to the market’s near-term direction. Two of those factors (interest rates and confidence) played out positively, as we had hoped, while the third (trade) remains unsettled but appears to be approaching some degree of resolution.
Monetary policy is neutral-to-stimulative not only in the US, but also in Europe. In China, the government has embarked on an aggressive program to spark the nation’s sputtering economy, whose weakness is helping to dampen growth throughout much of the rest of the world. If successful, the program would provide a welcome boost to global growth.
Yet there are areas of potential concern:
- The yield-curve inversion that happened in late March, which prompted fears of an approaching recession. While it certainly bears monitoring, we are not overly concerned for several reasons:
- The inversion occurred between three-month T-bills and the 10-year Treasury—in other words, not between the two-year bill and the 10-year, whose inversion is considered the strongest historical indicator of recession.
- We believe the US economy will experience muted growth in the medium term (i.e., the next 12–18 months) and won’t enter recessionary territory.
- Credit spreads, which we’re closely monitoring. A widening would signal a decline in risk appetite or an increase in recessionary fears.
- Weakness in non-US economic growth. In addition to China, the most significant risk is in Europe, where danger lurks in the form of Brexit, the UK slowdown, deterioration in Germany and Italy, and a potential Italian debt crisis.
WHERE WE STAND NOW
Strong earnings growth will be harder to achieve—which is favorable for companies that can meet or exceed their forecast earnings. Growth typically has the edge over value when this is the case.
- US economic growth is slowing but still solidly positive.
- Global economic growth is decelerating, underscored by data such as OECD leading indicators and purchasing manager indices for numerous major economies.
- Q1 S&P 500 earnings expectations have meaningfully fallen as the impact of one-time tax reform benefits recedes.
- As earnings revisions continue to right-size, less than 40% of small-cap companies are expected to deliver greater than 20% growth, according to Jefferies research.
Focusing on secular growth down-cap. Scarcity of earnings should benefit the stocks of strongly growing companies. In this environment, we’re focusing on dynamic companies whose disruptive innovation and differentiated business models can drive secular growth (i.e., not dependent on GDP growth). Active management and selectivity will be critical at this late stage in the economic cycle, particularly as passive ETFs magnify crowdedness around many stocks and thus increase downside risks.
Our portfolios are well positioned. We’ve invested our portfolios both in companies whose potentially superior earnings growth could lead to outperformance in the slower-growth environment we’ve described, and in those whose businesses are domestically focused. The latter companies are less vulnerable to global economic weakness and could experience a significant earnings boost if the US-China trade situation is resolved or China’s stimulus program starts to show results.
Favoring health care, tech and consumer discretionary. These are our biggest sectoral exposures, and we believe they have compelling upside potential based on a combination of strong demand, high-quality balance sheets and attractive valuations.
Earnings season will be telling. We will be scrutinizing reported numbers and managements’ forward guidance announcements for signals on business confidence and, therefore, the direction of market valuations.
Disclosure: Nicholas Investment Partners, L.P. (“Nicholas”) is an independent investment adviser registered with the SEC. Registration with the SEC does not imply a certain level of skill or training. The firm maintains a complete list and description of performance composites, which is available upon request. Policies for valuing portfolios, calculating performance, and preparing presentations are available upon request. Past performance is no guarantee of future results. No part of this material may be copied or duplicated or distributed to any third party without written consent.
Nicholas does not guarantee the success of any investment product. There are risks associated with all investments and returns will vary over time due to many factors such as changing market conditions, liquidity, economic and other factors. The value of investments can go down as well as up, and a loss of principal may occur. Although Nicholas attempts to limit various risks, risk management does not imply low risk. All risk models are inherently limited and subject to changes in economic, political and market conditions, as well as changes in the strategies’ holdings, among other things, which could affect the risk profile of any portfolio managed by Nicholas. Small- and mid-cap companies may be subject to a higher-degree of risk than larger more established companies’ securities. The liquidity of the markets for these small and mid-cap companies may adversely affect the value of these investments. Concentrated or sector strategies are expected to maintain higher exposures to a limited number of securities or sectors which could increase the volatility, market, liquidity and other risks of the strategy.
Some information herein reflects general market commentary and the current opinions of the author which are subject to change without notice. It is provided for general informational purposes only and does not represent investment, legal, regulatory or tax advice and should not be construed as a recommendation of any security, strategy or investment product. There is no guarantee any opinion, forecast, or objective will be achieved in the future. The information, charts and reports contained herein are unaudited. Although some information contained herein was obtained from recognized and trusted sources believed to be reliable, its accuracy and completeness cannot be guaranteed. Unless otherwise noted, Nicholas is the source of illustrations. References to specific securities, issuers and market sectors are for illustrative purposes only. Nicholas does not undertake to keep the recipients of this report advised of future developments or of changes in any of the matters discussed in this report.
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