“There is nothing more fulfilling than to serve your country and your fellow citizens and to do it well.”
George H.W. Bush
The most important message in this year-end edition of Market Monthly is one of thanks. As the late President Bush reminds us above, it is truly fulfilling for the opportunity to serve each of our clients and their families. We value and appreciate each client and associate relationship, and we simply want to say, thank you.
In this abbreviated holiday version of Market Monthly we briefly recap some of the key themes we discussed this year before setting our sights on the year ahead. Our 2019 Outlook Edition will be released in January 2019.
January 2018 began with explosive performance and high-growth expectations from recent tax cuts. Rising wage inflation was a catalyst for the February correction as interest rates spiked at a time when S&P 500 valuations were already stretched. This set the stage for renewed bouts of volatility for the balance of the year. A flat yield curve, elevated geopolitical tensions and trade disputes all contributed to a retracement of this summer’s fast pace of economic growth. Growing concerns of a slowing economy have propelled an ongoing corrective phase for equities since the September record highs. Global equity markets are now on pace to finish the year somewhere between a correction in the U.S. and a bear market internationally.
Many themes from our Jan. 22, 2018, Outlook edition played out as expected while others did not. For example:
Themes that did not work:
- Continuance of globally synchronized growth: The impact of U.S. tax cuts caused U.S. economic growth to outpace most other world economies.
- International market outperformance: International markets followed the path of their economies underperforming the U.S.
- Favor stocks over bonds in 2018 but expect rising rates to challenge financial asset prices later in 2018: This was a mixed bag with U.S. stocks modestly outperforming bonds in 2018 but with international stocks underperforming. Our U.S. market overweight had a modest positive impact.
Themes that worked:
- The Fed will hike more than markets imply remaining on their quarterly rate hike path.
- Tax cuts expected to add roughly .5% to GDP growth.
- Currently easy financial conditions will begin to fade into 2019 as rising rates take hold.
- 2018 is likely to be a “keep your coupon” best-case scenario for bond returns.
- Equities transitioning from a steep return/low volatility regime to a modest return/rising volatility regime.
- We expect double-digit earnings growth in 2018 with a tailwind from corporate tax cuts.
- Tariff discussions on Chinese imports could resurface causing market interference.
- Republicans on track to lose 30 or more seats returning the House to Democratic leadership.
Challenging Multi-Asset Class Performance:
Performance has been elusive in 2018 regardless of asset class or geography making for a challenging asset allocation environment. The chart below reveals YTD performance (in order of best to worst) as of
Dec. 16, 2018, for a broad range of global asset classes.
- Large Cap U.S. growth stocks topped the list of positive performers.
- U.S. stocks outperformed bonds as expected by a razor-thin margin.
- The U.S. dollar outperformed international currencies due to rising rates and economic strength.
- Municipal and corporate bonds outperformed broad bond indices.
- Cash (T-Bills) re-emerged as a destination asset class due to rising interest rates.
- Poor international equity performance was amplified by weak international currency returns.
- Commodities, though not a core part of our strategy, also underperformed.
2018 was a challenging year for asset allocation as few asset classes were spared. Correlations among asset classes rose throughout the year as global assets fell in synchronization with fears of global economic slowdown, rising U.S. interest rates, trade policy uncertainty and geopolitical instability.
2018 was a year much like 2015 with balanced asset allocation strategies performing in a tight range regardless of risk profile. Rising correlations between asset classes provided fewer opportunities to add incremental return or reduce incremental risk. The chart below offers a hypothetical sample of returns across multiple asset-allocation objectives using broad index results through the Dec. 14, 2018, market close.
At the current pace, 2018 will mark just the fifth time in 70 years where both U.S. stock and bond returns have been below 4%. The previous four occasions (1953, 1969, 1977 and 1994) were followed by better than average years the very next year. This is an observation, not a prediction.
The Path Ahead in 2019:
Though we will provide you with our more comprehensive 2019 Outlook in our January edition of Market Monthly, we can give you a preview of what some key topics will be. One of the most critical factors to our Outlook rests on the trajectory of the economy and its impact on financial asset prices both here and abroad. We will view the market outlook through three lenses and assign a probability to each. They are:
- Trend Growth: The economy returns to trend GDP growth of 2%-2.5% from its tax-cut induced pace of 3%+ in 2018.
- Soft Landing: The economy avoids recession but is subject to consecutive quarters of below-trend economic growth.
- Recession: The economy endures consecutive quarters of negative GDP growth.
Monetary policy, economic behaviors and market impact under these three scenarios are vastly different as are the interaction between U.S. and international economies.
The U.S. economy is expected to slow from its 2018 pace but not enter recession. Fed policy will remain on the front burner and the impact from tax cuts will begin to fade. Lingering trade policy uncertainty remains a risk but a “compromise” deal between the U.S. and China is not out of the question in a year before U.S. presidential elections. Debates surrounding the U.S. debt ceiling will be spirited and could remind us of the 2011 standoff. International economies have watched with envy as the U.S. economy outpaced their growth due to tax cuts. As a result, an increasing number of countries are considering tax cuts, increased government spending or both to jump start their economies. This could have a positive impact on international markets later in 2019. A return to trend growth in the U.S. is our current baseline expectation.
Short-term yields have risen and T-Bills now generate 85% of the yield offered by a 10-year T-Note. As a result, we expect a continuing shift from a “hunt for yield” bond strategy to a renewed “shelter of safety” strategy. Further pressure to corporate yield spreads could be a source of concern in the lower quality space but an area of opportunity in the investment grade space. Yields could rise once again in 2019 but are likely to remain range bound.
Earnings expectations continue to be revised downward with a fading impact from tax cuts and an expectation for slower economic growth. Firmer earnings expectations could arise from a resolution to trade disputes, a pause by the Fed or a weaker dollar. Stocks perform better in an environment of accelerating earnings and perform poorly in an environment of decelerating earnings. This could set the stage for continuing pressure into the first quarter of 2019 with a potential recovery in the second half of 2019. Slower economic growth in early 2019 could continue to support growth stocks while any renewed cyclical recovery in later 2019 could provide support to value stocks. The biggest risk to U.S. equities would be a larger-than-expected economic slowdown with an earnings recession as a worst case scenario. Absent an unexpected slowdown, 2019 equity markets should outpace 2018 but investors may have to wait for the back half of the year. Remember, it is “time in” the market rather than “timing of” the market that works over time.
Thoughts on the Ongoing Correction:
As we discussed last month, there has been considerable technical damage to the S&P 500 that will take time to repair. The chart below reveals that:
- 75% of the S&P 500 remains in correction territory (down 10%+)
- 51% of the S&P 500 remains in bear market territory (down 20%+)
- 25% of the S&P 500 is down 30%+
- 68% of the S&P 500 is below its 200-day moving average
- 57% of the S&P 500 has a 50-day moving average that is below its 200-day moving average
It will take several days of strong market breadth to make meaningful market repair. This requires advancing issues and volume to convincingly outpace declining issues and volume. The market may play “wait and see” until Q4 earnings are released in January. The pace of earnings downgrades/upgrades will be watched closely, but the verdict may remain out until we see how stocks react to Q4 earnings. A Fed pause in March and a trade resolution are key ingredients to removing some of markets hangover. In 2019, U.S. stocks are most likely to trade in line with their earnings growth, which is in the 4%-8% range. Patience is a difficult but necessary exercise for successful long-term investors.
In our August Market Monthly we suggested a three-step approach to asset allocation. Those steps in increasing degrees of severity are:
- Rebalance Your Existing Strategy: This is an ongoing activity regardless of conditions.
- Reduce Market Risk Within Your Existing Asset Allocation: Becoming more defensive as economic growth reverts toward trend growth may make sense.
- Tactical Risk Reduction: Reduce exposure to risk assets (stocks) when recession indicators become elevated.
We will revisit these more fully in our 2019 Outlook.
Markets have been held hostage in 2018 by a wide variety of late-cycle risk factors that will remain with us in early 2019. Absent any convincing case for a U.S. recession, 2019 should offer investors a better result than 2018 especially later in the year. Historically, markets have performed well in the late stage of an economic recovery so staying the course should be the best course.
Once again, thank you for the opportunity to be of service to you. We wish you a blessed Christmas and a happy holiday season.
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors
This piece is produced by BB&T’s Wealth Portfolio Management Team.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.