The last couple of weeks has been a microcosm of 2018—higher volatility and more violent moves by stocks. Heading into 2019, we think we’ll see more of the same, with investor patience likely to be tested.
Economic growth is slowing, but not yet to the point of threatening a recession in the near term. Risks have risen, as evidenced by the flattening of the yield curve, with the Federal Reserve and trade relations with China holding near-term keys to both the degree of slowing and market volatility.
Uncertainty is high in the United Kingdom (UK) as the Brexit vote comes down to the wire, but it isn’t necessarily a binary outcome.
“If you want to see the sunshine, you have to weather the storm.”
— Frank Lane
The past few weeks have been a fair representation of the majority of the year, with higher volatility, sharp moves on the down side (with sharp counter-trend rallies), a focus on the Fed and trade relations. Discipline and defense and have been warranted this year; and likely will again heading into next year. Starting late last year, we made several tactical recommendation changes which brought our overall global equity recommendation to slightly underweight—with a relative overweight to U.S. large cap stocks and a relative underweight to emerging markets (EM). This past August, we lowered our rating on the technology and financial sectors (from outperform to neutral) and raised our rating on the utilities and REITs sectors (from underperform to neutral); thereby leaving only healthcare with an outperform rating. With a corresponding underperform to communications services, our sector recommendations clearly have a defensive tilt.
We believe the second market correction this year, which has recently picked up steam, was largely brought on by three major worries: peak economic growth, Federal Reserve policy (and the related inversion of a portion of the yield curve), and trade/tariffs uncertainty. With regard to the first, the International Monetary Fund (IMF) recently downgraded its view of U.S. economic growth, with a projected 2.9% growth rate in 2018 decelerating to 2.5% in 2019; while the Bloomberg consensus has growth declining to 2% year/year by the end of 2019. We will likely arrive at next July with the expansion still ongoing, which would mean this would be the longest post-WWII expansion ever. However, the risk of recession is increasing and trade may hold a key to the length of runway between now and then. Concerns about a hawkish Federal Reserve eased somewhat last week after Fed Chairman Jerome Powell said rates were “just below” the Fed’s estimate of neutral, neither stimulating or restricting growth or inflation—a notable change from his comments in early–October, when he said that rates were “a long way” from neutral. As you can see in the chart below, following those recent comments from Powell, expectations for 2019 rate increases fell and now only one rate hike is expected next year.
Powell’s comments reduce Fed rate hike expectations
On trade, while there were some conciliatory comments coming out of the G-20 meeting, with a 90-day “truce” being announced, little actual progress in the China/U.S. trade dispute has been made to this point—not to mention the conflicting information flow from both sides—leading to continued uncertainty heading into 2019 (for more on the U.S./China Truce read Truce: He Said, XI Said).
It is becoming clearer to us that we have likely seen an inflection point in the U.S. economy, with a peak real gross domestic product (GDP) growth rate of 4.2% in the second quarter, slowing to 3.5% in the third quarter and expected to slow again to 2.7% in the fourth quarter; and then decelerating further from there in 2019. The burning question is by how much? For now, neither the still-rising leading indicators nor the yield curve suggest an imminent recession is in store, although risks have clearly risen.
On the subject of the inverted yield curve—when shorter duration rates are higher than longer term rates—that has only happened at one part of the curve (sometimes called the “belly” of the curve), with 2-year yields moving above 5-year yields. Along with the flattening in the more stock market-relevant 10-year to 3-month spread, it suggests rising concern about economic prospects. However, historically it typically tended to take many months before serious trouble for either the economy or stock market ensued. But the yield curve isn’t the only economic “prognosticator.” Financial conditions have weakened recently according to the Chicago Federal Reserve National Financial Conditions Index, housing has slowed across nearly all metrics, and business optimism surveys have shown signs of rolling over. For those looking for some sun amid the clouds, there were rebounds in the latest ISM Manufacturing and Non-Manufacturing Index readings, while the new order components—forward looking indicators—also rose nicely.
Housing activity has slowed
And optimism may be softening
There remain other supports for the U.S. economy, including a Fed that has backed off some of its more hawkish rhetoric, consumer confidence remaining healthy (aided by the plunge in oil prices), and longer-term interest rates having retreated. The aforementioned collapse in oil prices is a double-edged sword however: although it’s a prop for the consumer, it’s a negative for energy-related capital spending and employment, as well as for energy sector earnings. Recall the double-plunge in oil prices in late-2014 and early-2015, which nearly singlehandedly took S&P 500 into a four consecutive quarter earnings recession from mid-2015 to mid-2016.
But consumer confidence remains healthy…
…and interest rates have backed off…
…while the fall in oil is a plus to consumers (but could hurt capex)
Our view is that the largest near-term unknown is trade. Consensus estimates point to a roughly one percentage point reduction in U.S. GDP growth if the threatened 25% tariffs on all Chinese imports go into effect. And that hit does not include the ripple effects through the business/consumer confidence and/or inflation channels. The flipside is also possible: a good deal with China could help to re-establish animal spirits, accelerate capital spending and likely send stocks higher.
Washington will remain in focus
While Powell’s comments helped ease investor concern, at least temporarily, there is still uncertainty regarding the future path of Fed policy; which has moved from a somewhat-preset course to a more data dependent path. The Fed has no stated desire to slow growth appreciably; while for now, the inflation outlook remains relatively benign—hence the lowering of expectations for next year’s rate hikes.
Inflation putting little pressure on the Fed
It’s important to remember though that inflation isn’t the Fed’s only mandate—there is also employment. The labor market remains tight, with the unemployment rate just reported at 3.7%, remaining at an historically low level, while adding another 155,000 jobs according to the Department of Labor. However, Chairman Powell, as recently as October as reported by the Wall Street Journal, said he doesn’t see evidence the labor market is at risk of overheating or of pressuring up prices (the dreaded “wage-price spiral”).
Separately, with the midterm election in the rear view mirror, the new Congressional mix means there exists the possibility of market-influencing legislation coming down the pike. We believe the general path will be gridlock, which can sometimes be comforting to the market. That said there is the possibility of an infrastructure spending deal on the upside, while it seems that threats of a government shutdown will persist and could add to market volatility.
Brexit: Deal or No Deal
Governmental problems appear even more pronounced across the pond as more than two years after the Brexit vote, the European Union (EU) and U.K. Prime Minister Theresa May completed a Withdrawal Agreement in November—but it’s not a done deal yet. The agreement faces opposition ahead of a U.K. parliamentary vote on December 11. May contends the choices are this deal, no deal, or no Brexit. The EU has said they are not open for further negotiation.
A vote in favor of the deal, leading to an orderly exit from the EU, would likely be welcomed by the markets. However, the deal has mixed support, and the majority of members of Parliament may vote no. Although there may appear to be a simple binary outcome of deal or no deal, with a positive or negative market reaction, we see multiple “no deal” scenarios with varying degrees of impact on the U.K. economy and markets.
Putting up the tree: Brexit decision tree
Source: Charles Schwab as of 12/4/2018. For illustrative purposes only.
Disorderly - The worst case “no deal” outcome would involve no transition period and a potentially disorderly exit, acting as a shock to the U.K. economy and markets. At the end of March 2019, the U.K. would be out of the EU. This is forecasted to have a substantially-negative immediate and longer-term impact on the U.K. economy, estimated by the Bank of England to be in excess of 7% of GDP, as well as a sharp rise in the unemployment rate from 4% at the start of 2019 to over 7% by early 2020.
Disruptive - Fortunately, there are other “no deal” scenarios. For example, there could be no deal on the future trade relationship, but still an agreement on the much less contentious divorce settlement of 39 billion pounds that comes with a transition period to determine the future trade relationship. The transition period would run from March 29, 2019 to December 30, 2020 (if both the EU and U.K. agree they could extend that period another two years). That is a long time and would mean a drawn out period for changes to take place. All the while, companies would continue preparing their businesses in anticipation of any potential disruptions. This outcome would be very different from an abrupt Brexit and may not be nearly as negative for the U.K. economy or markets.
Others - There are other “no deal” outcomes as well. There is the potential replacement of May as Prime Minister through a vote of parliament, or her resignation, which would be a very uncertain scenario with little time left for new negotiations. Potentially, the U.K. could also ask the EU for more time. An extension of the exit discussions would require the unanimous support of all EU governments, but would give May more time to secure a deal that Parliament could accept, or to better prepare the country for a no-deal exit. There is also the possibility of another Brexit referendum. If a second referendum reversed the first, it would likely need to do so by a wide margin for market participants to believe the issue was resolved.
Prime Minister May needs roughly 320 votes in the House of Commons to secure the approval of the Brexit deal. The Conservative Party controls just 315 seats, meaning she would have to rely on support from outside her party to succeed, even if she wasn’t facing a revolt from a significant number of hardline members of her own party. The opposing Labour party’s official position is a no vote, against the deal.
Another possibility is for a second vote to pass in Parliament, after the first vote fails. This would be a similar path to the U.S. TARP (Troubled Asset Relief Program) that, after much criticism by U.S. lawmakers, failed to pass the U.S. House of Representatives in late 2008. Stocks reacted with the largest drop since the crash of 1987 and a revised bill passed the U.S. House a few days later.
A “no deal” outcome on December 11 could trigger a sharp drop in the U.K stock market and a U.K. recession, but there are scenarios where the impact might be fairly mild instead. We continue to foresee volatility for the U.K. market, but relatively little risk of broad contagion given a well-capitalized U.K. banking system. Markets seem to be at least partially braced for a “no deal” outcome already, with a sizeable drop in both the U.K. currency and stock market. Yet, a further decline isn’t out of the question, nor is a rebound on a less disorderly outcome.
The end of 2018 will likely morph into more of the same in 2019—higher volatility within a relatively wide equity range, including ongoing corrective phases or even a continuation of what has been a “stealth” bear market this year (rolling bear markets across and within asset classes). We believe economic growth will slow but not to the point of recession in the near term; although risks have risen, with the focus on interest rates and trade. Things are even more uncertain across the pond, but there are potential relatively positive outcomes along with the well-known worst case scenarios. Stay disciplined and defensive and keep a focus on your longer-term plans.