A growing US economy, rising employment, wage gains, low inflation and buoyant consumers are among the bright spots to highlight as we start 2019. Mid-single-digit returns across the equity markets and low-single-digit returns for bonds are achievable this year. But risks are rising, too. Read on for a review of 2018, a discussion of how we see 2019 unfolding, and thoughts on how to position your portfolio.
Review of 2018
We started 2018 with lofty expectations for global growth and, with the perspective of hindsight, high global equity valuations. Equity markets began to struggle in February, initially mostly outside of the US as the macro backdrop worsened and global growth decelerated. And political risks increased, including the US-China trade war, problems in Italy, and Brexit. The US appeared to have de-coupled from the rest of the world in 2018, with the domestic economy expanding above 3% and equities solidly in the black year-to-date at the end of September.
2018 Returns (%): Well Below Long-Term Averages
But re-coupling came in the 4th quarter, with concerns over US growth deceleration due to fading fiscal stimulus, tightening financial conditions and increasing political uncertainty. The Federal Reserve Chair communicated in a market-unfriendly fashion, and the Fed continued to raise short-term interest rates.
Risky assets nose-dived. In 4Q18, US large cap stocks fell over 13%, small caps dropped 20%, and high yield bonds declined by 5%. For many investors, the only segments of their portfolios that produced positive returns in 2018 were short-term bonds and cash.
Outlook for 2019
As the calendar turns to the new year, we recognize a number of bright spots. In the US economy, the jobs market is strong, wages are on an upward trend, consumers are spending and inflation is low and seems to be contained. On the policy front, the Federal Reserve appears to be moderating its tone and it may exercise more patience as it contemplates the costs and benefits of further monetary policy tightening. Also, the incentives are high for the US and China to strike a trade deal, and negotiations are under way. We think the US economy will continue to grow in 2019, but less vigorously than last year – likely at a rate below 3%.
Global Stock Valuations Have Reset Lower
With regard to stock prices, there was a pronounced reset in valuations. In 4Q18, prices fell much faster than earnings revisions. By some measures, such as the price-to-earnings ratio, stock valuations are now well below long-term averages. In the past, when investor sentiment has gotten to extremes, a stock-price reversal often hasn’t been far off. While we wouldn’t characterize it as a bright spot, today's investor sentiment may be a signal that a reversal in prices - to the upside - is possible.
Expected Returns for 2019. With regard to expected returns for 2019, ultimately we believe the bright spots will carry the day. We think mid-single-digit returns across the equity markets are achievable. Generally speaking, after two well-above-average return years (2016, 12% & 2017, 21.8%) and two well-below-average return years (2015, 1.4% & 2018, -4.4%), a year of average returns for equities seems about right to us. For fixed income, we believe inflation will be contained and the Federal Reserve will move forward with more caution. We don’t see 10 year rates rising much above 3%, which would indicate bonds are likely to produce low single-digit returns in 2019.
Our return expectations are tempered by a preponderance of risks, especially in politics and the business sector and also due to declining liquidity and rising debt burdens. Below we flush out our thinking on these vulnerabilities.
Risk #1: Politics & Governance. Formulating policies online by tweet rather than offline through established channels is a new phenomenon. Dialogue on key issues can occur unexpectedly, shift rapidly, and at times seems to be done in an arbitrary fashion. This injects greater uncertainty into many aspects of economic life. For example, the tariff and trade issues are causing business leaders to exercise more caution. Calling into question the independence of the Federal Reserve has unnerved investors. And the partial government shutdown could impact the spending decisions of a significant group of consumers.
These current political issues that are weighing on the market may be ironed out over the near term. However, the White House’s approach to making policies and governing translates to more surprises, greater uncertainty, and ultimately a wider variance of potential outcomes. This heightened uncertainty makes business planning and risk taking in the financial markets more difficult.
Risk #2: Business Activity. It seems highly likely that we have passed peak corporate earnings growth for this business cycle. For 2018, earnings likely grew more than 20% compared to the prior year. For this year, the current analyst consensus forecast sits at about 8% growth. Earnings expectations are being reset, and it's possible that we see further downward revisions. Recent data from the business sector has been soft. For example, manufacturing orders, typically viewed as a forward-looking indicator, weakened considerably in December.
In addition, we are getting negative vibes from some key business leaders, who are voicing concerns about slowing growth outside the US and trade tensions. For example, in mid-December FedEx CEO Fred Smith said “the peak of growth seems to be behind us.” He cited significant weakness in Europe and China, and lowered 2019 earnings guidance. FedEx stock dropped 8% and the S&P 500 fell 1.5% on the same day.
And in early January, Apple CEO Tim Cook said the company would miss its quarterly revenue and earnings targets for 1Q19. He cited unanticipated weaker demand in China, and specifically that the contraction in Greater China’s smartphone market has been “particularly sharp.” Apple stock dropped 10% and the S&P 500 fell 2.4% on the same day.
The risk is that financial flops like FedEx and Apple become regular occurrences. This would imply a broad-based deceleration of business activity and downward pressure on stock prices. Earnings season is nearly upon us. Senior executives at many large US corporations are due to discuss business conditions and provide forward guidance starting in mid-January.
Risk #3: Liquidity & Debt. If concerns about politics and business activity are monkeys on the market’s back, then liquidity and debt dynamics are an 800 pound gorilla. The combination of falling liquidity and rising debt levels may prove to be a sizable headwind for the markets in coming quarters.
Since the financial crisis of 2008, the big central banks have been providers of liquidity, lowering short-term rates and keeping them at historically low levels, and using their balance sheets to push trillions of dollars into the financial system. This led to a healthy demand for risky assets like stocks and high yield bonds.
But the Federal Reserve has been the first central bank to start reversing its ‘easy money’ policies by raising rates and reducing the size of its balance sheet. This withdrawal of liquidity picked up pace in 2018 and has been one of the reasons behind wider stock price swings. It’s not clear how quickly or how far the Fed, or other central banks, will go in raising rates and shrinking their balance sheets. However, we expect this uncertainty to persist for some time and to be a source of volatility for the markets in 2019.
Along with liquidity, the build-up of debt is on our radar. US federal government debt is at its highest point relative to GDP since the 1940s and continues to grow. Also, many companies have pushed their debt burdens higher in the current low-rate environment. Debt can help to accelerate economic activity and stock prices when times are good. However, debt can turn into a retardant when the economy slows.
The bottom line is that we think we are closer to a time when the economic cycle turns down, and when liquidity and debt dynamics start hurting instead of helping. Of all the risks we’ve highlighted, this one may take longer to play out, but in the end may have the biggest impact on investors.
Portfolio Positioning. Where does this leave us with respect to portfolio positioning for 2019? In the current environment, we favor a ‘lighter on risk, heavier on safety’ approach. In the context of asset allocation strategy, we favor adjusting to a lower risk profile relative to your benchmark for riskier assets like stocks and some areas of the bond market, including high yield.
It’s also important to recognize the role that cash and short-term bonds play as a ballast against volatility and as a way to preserve capital. In order to grow your wealth over the long term, staying invested is critical. Staying in tune with vulnerabilities and making adjustments in your portfolio's risk tenor when conditions warrant is equally important.
Rob Kania is a Principal and Co-Founder of Laurentide Advisory
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Article Notes & Disclosures: Asset Class Returns Table Source: Morningstar. EM Stocks: MSCI EM; DM Stocks: MSCI EAFE; Commodities: Bloomberg Commodity Index; US Small Stocks: Russell 2000; US Large Stocks: S&P 500; REITs: S&P US REIT; High Yield Bonds: ICE BoAML US High Yield; Credit: Bloomberg Barclays US Intermediate Credit: Treasuries: Bloomberg Barclays Intermediate US Treasury; Cash: Bloomberg Barclays 1-3 Month Treasury. Source: Global Stock Valuations Chart Source: JP Morgan Asset Management, Guide to the Markets 1Q 2019 Disclosures: please click here for important disclosures.
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