What is it about the global economic landscape, and the U.S. equity markets, that would send the S&P 500 down – 13.52% in the fourth quarter of 2018 only to rebound by + 4.20% over the first ten trading days of the new year? Can we glean any insights that would help us reshape asset allocations? Are the key macro-economic trends pointing to trouble ahead?
Economic growth in the U.S. is slowing from its recent pace of growth but is still likely to be in the 3% (real GDP) range for 2019 which is impressive. Unemployment is projected to continue to fall and should end 2019 close to 3.2% (a significant reduction from 4.7% at the end of 2016). Corporate earnings are beginning to be reported, but the consensus heading into earnings season is for another quarter of double-digit growth with continued growth in 2019 expected. Therefore, we have clear signals of sustained growth in the U.S. and no visible “bubble concerns” across various sectors of the economy.
In addition, inflation has softened dramatically, aided by the recent precipitous drop in oil prices, and will likely fall below 2%. The impact of falling oil prices produces multiple benefits for the economy to include prolonging the current economic expansion and reducing the pressure on the Fed to raise rates.
Finally, the story on interest rates is also a positive one. Although the Fed raised interest rates three times in 2018, the overall level of rates is still not restrictive when compared to nominal GDP growth (real GDP + inflation). Nominal GDP is over 4.5% as compared to a 2.5% target for the federal funds rate. As noted above, the Fed has lost a reason to raise rates given inflation expectations, and the flatness of the yield curve (difference between short term and long-term interest rates) will likely make the Fed cautious about moving rates too far in the short end in order to avoid triggering a “yield curve inversion” (short rates higher than long rates). Many believe that inverted yield curves signal a looming recession and are a drag on economic growth.
Continued economic growth, positive corporate earnings, low inflation and low interest rates should be a solid foundation for another positive year in 2019 for U.S. equity markets.
What might derail this constructive outlook supported by the positive trends noted above?
The unresolved trade negotiations with China are a headline getter, fostering uncertainty, and over time, can generate a drag on growth. Most economists expect a trade deal later this year so this threat will either morph into a market positive or re-emerge later in the year as source of concern.
Another government shutdown in the next couple of weeks would likely contribute to further negative market sentiment. However, in past shutdowns the negative impact usually is replaced by an uptick in growth once the deferred expenditures return to the economy.
One more volatility-generating headline will likely be the government debt ceiling which expires on March 8th. If the dysfunction in Washington cannot address our government’s ability to borrow, then expect markets to react negatively. However, the Treasury does have a work around which will likely dampen any debt ceiling crisis.
The flip side of low inflation and low interest rates is the risk of a curve inversion leading to recession and the Fed’s inability to prevent the deflation which accompanies an economic downturn. This threat exists in multiple markets around the world, highlighting the importance of central bank policy execution in the current global economic environment.
Finally, Chinese economic growth is getting attention again. We were recently in Hong Kong meeting with a senior official in the Hong Kong Monetary Authority in order to gain a better understanding on the economic trends in the region. He reminded us that China still had capacity to leverage balance sheets in the financial sector should the pace of growth slow too much. It was interesting to return home and then see the headlines in the US press about the Chinese perpetual bonds which are being issued to support bank capitalization and lending. The Chinese still have tools at their disposal and a demonstrated resolve to support growth.
Overall, we expect the market trends to remain generally positive for the coming year. We do not see key macro-economic indicators pointing to near term trouble ahead, but late cycle volatility and trading-driven down drafts will most likely punctuate the landscape. If the fourth quarter reminded us of anything it is the importance of maintaining a diversified, risk-based asset allocation to provide support in times of market dislocation and a prudent level of risk assets to capture upside potential when it presents itself.