The stock market rebounded in the first quarter as the U.S. Federal Reserve (Fed) pivoted on its intent to raise interest rates and on the speed with which it will be reducing its $4 trillion asset portfolio. The result was clear: long-term interest rates declined and risk assets rallied. During the first quarter, the S&P 500® gained 13.65%, the Russell Midcap® advanced 16.54%, and the MSCI EAFE® returned 9.98%. Bond returns were positive during the quarter as longer-dated interest rates declined despite short-term rates remaining pegged near the Fed mandated level. The Bloomberg Barclays Intermediate Government/Credit Index returned 2.32% and the Bloomberg Barclays Aggregate Index advanced 2.94% during the quarter.
We opined last quarter that “investors have merit in their concern as central banks withdraw liquidity - arguably one of the key drivers of asset prices.” Indeed, many believe the primary catalyst for the first quarter stock market rally was the near 180 degree turn the Fed made in early January. Just months before, at the September, 2018 Fed meeting, Chairman Powell implied the central bank would continue to increase short-term rates while also shrinking its balance sheet (i.e. quantitative tightening) at an accelerated rate of $50 billion/month. This position was confirmed in December when the Fed voted to raise interest rates another 0.25% and signaled that two more increases were likely in 2019. The U-turn in Fed policy occurred shortly thereafter and was memorialized in the minutes of the January, 2019 Fed meeting when the central bank acknowledged it would be “patient” in considering further interest rates hikes and would be flexible in reducing its holdings of Treasury and mortgage-backed securities. The minutes also confirmed that FOMC members were aware their actions had created destabilizing effects, pushing stocks and other risk assets into decline. The market’s response was robust as the S&P 500 Index gained over 20% from the low on Dec. 24 to the end of the first quarter.
It wasn’t just the Fed that shifted its stance -- the European Central Bank (ECB) also indicated it would keep interest rates below zero for longer than had been expected (until at least the end of 2019). Additionally, the ECB indicated it was planning new credit facilities for banks to induce them to make loans. These actions were likely driven by an acknowledgment of weaker economic growth as the central bank slashed its EU growth forecast to just 1.1% for 2019 (previously at 1.7%). In fact, both China and Europe are showing more indications of economic slowdown and there are few signs that trade tensions between Beijing and Washington are easing. The U.S. Treasury yield curve tipped into an “inversion” as the gap between 3-month and 10-year yields vanished at quarter end -- confirming the bond market’s worries of a global slowdown.
The stock market’s reaction to growing global uncertainty was in clear contrast to 2018, when earnings growth was exceptionally strong but stock prices actually declined and resulted in a lower price-to-earnings (P/E) multiple. Fast forward to the first quarter of 2019 and the opposite occurred – earnings expectations have steadily deteriorated yet stock prices have increased significantly. When viewed through a valuation lens, the price-to-earnings (P/E) multiple has expanded in 2019 despite a multitude of uncertainties, both domestic and global, political and economic. Indeed, one may wonder how stock prices can rise so dramatically when economic growth forecasts have declined and bond yields continue to signal softer growth. The answer, it seems, lies directly with expectations that central banks worldwide will keep a lid on interest rates and will be cognizant of their impact on risk asset prices.
Your portfolio performed in-line with the S&P 500® Index during the first quarter. The portfolio’s focus on high-quality stocks was a modest detractor from relative performance as investors embraced lower-quality, high growth stocks. Strong stock selection helped offset this headwind, allowing your portfolio to keep pace with the strong market. For the trailing twelve months, the portfolio, before fees, outperformed the S&P 500 by a substantial margin. Consistent with the strategy’s history, the portfolio’s downside capture ratio was resilient in late 2018, and the portfolio management team used the market volatility to add new investments and augment existing positions at opportunistic prices. We believe the portfolio management activity through the volatile period contributed to the portfolio’s first quarter return.
Stock selection was particularly strong in the Health Care, Industrials, Real Estate and Materials sectors. Conversely, stocks in the Technology, Consumer Discretionary, Communication Services, and Financial sectors lagged their peers. The sector positioning of the portfolio offset some of the strong stock selection. Your portfolio was underweight in the Technology and Energy sectors which both outperformed the market. Additionally, cash was a drag on performance in this rapidly advancing market.
The five top contributors to your portfolio’s quarterly return included: Jacobs Engineering (28.6%), American Tower (24.6%), Danaher (28.0%), Brookfield (21.6%), and Lowe’s (18.6%). The five largest detractors included: Covetrus (-14.6%), Henry Schein (-1.8%), Berkshire Hathaway (-1.6%), Omnicom (-0.3%), and Johnson & Johnson (0.3%). Covetrus was a fractional position that was spun-off from Henry Schein in the quarter; the portfolio management team sold Covetrus within the quarter.
With an environment of decelerating economic growth and shifting central bank policies, we believe financial markets volatility could remain high. Without doubt, the economic expansion will come to an end but predicting that point is nearly impossible -- making market timing a futile endeavor in our opinion. We continue to believe that investors are best served by choosing investments based upon time horizon and risk tolerance. This approach, along with investing in stocks of lower-risk, higher-quality companies and shorter-duration, higher-quality bonds, should allow us to participate in the markets while providing some shelter as market volatility and geopolitical risks persist.
“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office. Madison Funds are distributed by MFD Distributor, LLC. Madison is registered as an investment adviser with the U.S.
Securities and Exchange Commission. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority.
Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
S&P 500® INDEX: Widely regarded as the best single gauge of the U.S. equities market, this world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, it is also an ideal proxy for the total market.
Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index, which represent approximately 35% of the total market capitalization of the Russell 1000® Index. As of the latest reconstitution, the average market capitalization was approximately $3.7 billion; the median market capitalization was approximately $2.9 billion. The largest company in the index had an approximate market capitalization of $10.3 billion.
Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.
The MSCI EAFE (Europe, Australasia & Far East) Index is a free-float adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. These indices are unmanaged. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. fixed income securities. The U.S. Aggregate Index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS,and CMBS sectors.
Bloomberg Barclays U.S. Government/Credit Bond Index includes securities in the Government and Corporate Indices. Specifically, the Government Index includes treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year) and agencies (i.e., publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government).
All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.
“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office. Madison Funds are distributed by MFD Distributor, LLC. Madison is registered as an investment adviser with the U.S. Securities and Exchange Commission. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority.
Madison Investments shares all personnel and resources at their Madison, Wisconsin location. Statistical data is for the consolidated Madison organization. The Madison organization consists of its holding company, Madison Investment Holdings, Inc. and its affiliates: Madison Asset Management, LLC; Madison Investment Advisors, LLC; and Hansberger Growth Investors, LP. Asset information presented includes non-discretionary assets. Refer to each entity’s Disclosure Brochure for more information.