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The economy recently surprised markets with growth of 3.2% in the first quarter of this year. Given that consensus expectations were for a full percentage point lower, it seems that recent fears of imminent recession were badly overdone at the end of last year. While the GDP number for Q1 was very good, we should not get too excited. Some of this has been attributed to large increases in business inventories, a situation that is self-limiting. Business inventories increase when companies produce more goods than they are selling, and rising inventories is a signal that could go either way. Currently, in light of expectations of a pickup in consumer demand and spending, we expect that rising inventories do not indicate a problem in the economy. Nevertheless, the impact of this factor of exaggerated GDP growth recorded in Q1 is likely to be reduced in coming quarters as demand catches up with supply. Also, productivity has jumped by 3.6% in Q1, which is the fastest rate in 12 years, a good sign for future economic growth. We are watching this closely to see if it is sustained. In the event this type of growth continues, our appraisal of the odds of a recession in the near term will decrease dramatically.
The S&P 500 is trading right at its all-time highs, having fully rebounded from 2018's year-end decline. Currently the index is up 16.5% year to date at 2912 as of this writing. The outlook for stocks is mixed going forward. On the positive side, earnings reports have been very strong relative to expectations and consumer confidence and spending are forecasted to increase during 2019. With a benign monetary policy regime in place and official sign of inflation to be sign, the environment is positive. Balancing this view, we have seen an interesting development in the market's appraisal of company performance. It seems that for a long time, actual earnings (revenues-costs) has taken a backseat to top-line revenue (sales) in what has been awarded in the market. That appears to no longer be the case, and this means the cost side of the ledger is being looked at more, indicative of cost consciousness returning. This means that individual stocks are likely to be driven on their own merits going forward, less likely to move together with all stocks in the risk on/risk off manner we have grown accustomed to over the past decade.
Rates are low, with the 10-year Treasury yielding just 2.55% and the short end inverted. Rates are currently higher for 3-month T-Bills (2.413%) than 5-year Notes (2.344%). Additionally, in corporate bonds, you have to lock money up for ~5 years to get the same rate that our money market is currently paying. This can make it unattractive to invest in bonds inside of 5 years to maturity, because why lock up funds for several years for the same yield as a liquid cash balance? This has increased our current allocation to cash, which will serve us well when rates rise again or the market provides a strong opportunity.
While the Federal Reserve recently went on the record saying they see “no sign of inflation,” at the same time, we are also seeing in consumer packaged goods earnings reports that they are able to pass along higher costs and raise prices. While these are not necessarily part of the Fed’s inflation calculation, this could be signs that inflation is in the process of returning to our economy. If that is the case, we can expect yields to react higher, and the move may be exacerbated by many larger players having to reverse their positions based on the thesis that rates will stay low for a long time. We are cautious on fixed income exposure under the current conditions.
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