“You can’t go back and change the small things in your life without putting the other things at risk.”
Bill Gates founder of Microsoft
The Control-Alt-Delete command on computer keyboards was invented by IBM as a way to reboot a computer when it freezes up. The quote above is attributed to Bill Gates when asked why there isn’t one simple button to reboot or reset the personal computer. Although Gates would have loved a simple “reset” button, he focused on the big picture and did quite well as it turns out. Likewise, there is no simple button that can reset a market or portfolio when markets freeze up like they did in 2018. Even if investors could change an investment strategy in hindsight, that impulse may place the rest of their portfolio at risk of failing to achieve its future objectives.
As we begin 2019, global economies and markets find themselves at a fork in the road somewhere between a return to 2-2.75% trend GDP growth and a soft landing in the 1-1.75% range with a low probability for U.S. recession in 2019.
- Global markets have bounced from their oversold December lows.
- The “Powell Put” with the Fed’s “patient” tone supports risk assets like stocks.
- Global growth has experienced a soft patch, but U.S. data suggest low odds of a 2019 recession.
- Trade negotiations continue with even a partial deal considered a market positive.
- Global economies are mirroring the U.S. playbook by cutting taxes and increasing government spending to boost growth.
- U.S. earnings and revenues are firm with tighter profit margins on the horizon.
- Credit market fears have subsided with bonds and rates likely to trade in a tight range in 2019.
- Portfolio rebalancing is advised after a volatile last six months.
In this edition of Market Monthly, we will update some of these risk factors that contributed to the Q4 selloff and offer a guided outlook as markets seek to hit the reset button in 2019.
2018 offered investors few places to hide as it was the first time since 1972 that no major asset class gained at least 5%. January S&P 500 returns (best since 1987) broadly reversed some of the oversold conditions from December (worst since 1931) yet it remains 7.5% below its Sept. 21 all-time high. Markets shifted from one of the best risk-adjusted return environments in 2017 to one of the worst in 2018 with volatility likely here to stay.
The chart below illustrates returns across a broad group of investable asset classes for calendar year 2018 (orange) and January 2019 (red). To the right of the vertical line represents all those asset classes generating a positive return whereas to the left illustrates all those generating a negative return. January’s gains reflect against the backdrop of 2018’s losses as a near mirror image of loss and subsequent recovery with some of last year’s worst performers becoming this year’s best performers. (China, emerging markets, oil, small caps)
Takeaway: Diversification is more difficult to achieve when asset class returns move in the same direction like they did in 2018. While many asset classes have recovered some of their 2018 losses, an asset like oil that lost -19.55% in 2018 needs to gain 24% just to become whole again. Short-term market sentiment is a fickle thing, and the single largest factor impacting sentiment has been the Fed. Their previous hawkish tilt has now yielded to a ground game of “patience” and “appropriateness” helping markets partially reboot. A best practice asset allocation strategy after the volatility of the last few months is to simply rebalance.
Fed Update: A Powell Put
The “Bernanke Put” named after former Fed chair Ben Bernanke was a term coined as the Fed’s post-2008 policy was in part designed to support risk assets like stocks. Zero percent interest rates were the stock market’s best friend. The January FOMC meeting gave birth to the “Powell Put” as the Jerome Powell led Fed did an about-face away from a “preplanned” path for interest rates and entered a new mode of data dependent “patience” with a policy that is “appropriate” to not further elevate risk for an already slowing U.S. economy. Any signs of economic acceleration, however, could prompt the Fed to hike one or two more times, at most, later in the year.
As the red bars illustrate in the chart below, markets are assigning a 90%+ probability (according to the CME FedWatch Tool) for no more rate hikes for the balance of 2019.
Chairman Powell articulated three primary points.
- The fed funds rate remains the Fed’s primary active monetary policy tool.
- The Fed “will not hesitate” to make policy changes to its balance sheet normalization if adverse economic and financial conditions materialize.
- The Fed is prepared to use its full range of tools (QE) if fed funds policy becomes an insufficient policy tool to address economic weakness.
Takeaway: After four rate hikes in 2018, the Fed is prepared to load both barrels of the shotgun (lower rates and QE) if “cross-currents of risk” (a term he used twice in his Q&A responses) create new sources of financial imbalance. In addition to its dual mandate of strong jobs and stable prices the Fed remains keenly aware of the “cumulative” effect of other risks such as: lower growth abroad, muted inflation, trade, Brexit and recent soft economic sentiment data. The Fed will revert to making data dependent policy decisions as the incremental impact from tax reform wanes. Our base case is for a pause until at least June with rates already at the lower end of the Fed’s neutral range.
Economic Outlook: A Little Bit Softer Now
Economists often separate data into two categories:
Soft Data: Trends derived from sentiment surveys on opinions about the economy
Hard Data: Measurable economic data based on actual results
Recent consumer and CEO sentiment surveys reflect rising risks of an economic slowdown but not recession. Surveys taken in December and January during the government shutdown will be closely scrutinized to verify or vilify those results. Weaker consumer sentiment often leads weaker housing, auto and retail sales trends. Weaker business sentiment often leads future declines in capital expenditures because business decision makers are less certain.
The chart below illustrates that hard data can follow soft data. The dark blue line indicates the most recent Consumer Confidence survey that remains near record highs despite its recent dip. The red line reflects a similar survey for future expectations. A wide gap between the two often occurs prior to recessions shown in the shaded vertical bars. We suspect that recent weak sentiment data are exaggerated by the recent shutdown and will make a modest rebound; however, we also suspect the shutdown itself could impact Q1 GDP with a temporary drag of .25%-.5%. We will continue to monitor forward-looking economic indicators for signs of recession but, in aggregate, the risk of recession for the next 12 months is low.
Trade Update: The recent tone from both the U.S. and China has leaned more friendly. In the U.S., President Trump will want to avoid the negative optics around an increase in tariffs from 10% to 25% on Chinese imports in a pre-election year. In China, President Xi wants to avoid further contraction in tariff-induced manufacturing growth but without jeopardizing the Made in China 2025 initiative, which strives for greater Chinese technological and industrial independence. The next 30 days will include additional meetings between U.S. and Chinese trade delegations perhaps concluding with another summit between Presidents Trump and Xi in late February. In our view, even a compromise deal would be market positive, not because it would provide a lasting economic tailwind but because it would eliminate a near-term market headwind.
Fiscal Policy Update: As 2019 progresses, the benefits from last year’s U.S. Tax Cuts and Jobs Act will continue to contribute toward U.S. economic growth but at a decelerating pace. Fiscal easing with tax cuts and increased government spending have now caught on with China, France, Italy, Australia, Germany, Canada, Japan and the Netherlands each embarking on their own initiatives to jumpstart their economies. With many other global economies in contraction mode, this could be a market positive for later in 2019 that could resynchronize global growth albeit at lower growth rates than 2017. Stay tuned.
Economics Takeaway: The largest economic risk as we entered 2019 was a policy mistake on the part of the Fed, which has abated for now. Trade disputes and slowing growth in China and Europe as evidenced by contracting manufacturing data remain near-term risks but would have to materialize meaningfully to nudge U.S. growth lower. Recent soft data has begun to reverse with the shutdown behind us but will be closely monitored for persistent weakness before waving a yellow recession flag after 2019.
Equity Outlook: Markets front ran the January Fed meeting embracing a risk-on mentality. The “Powell Put” is one key component supporting a slight equity overweight in our asset allocation process. Removing a few more blocks of uncertainty from today’s economic landscape could give business decision makers and consumers a renewed sense of confidence to prime economic growth and earnings for 2H of 2019.
Fourth-quarter earnings have largely met estimates coming in at around a 13% growth rate. Top line revenue growth is also coming in at around 5.5%, which is a solid indicator of healthy organic earnings. With 75% of the S&P 500 having reported results, we expect resumed share buybacks to renew demand for U.S. shares. This is significant in that corporations have been the largest buyers of their own stocks.
For calendar 2019, we expect earnings growth to moderate from last year’s tax-cut induced 20%+ pace back toward a more earthly 5-6%. A base case would be for U.S. stocks to trade in-line with earnings growth going forward.
Weakness in the U.S. dollar could cause U.S. multinationals and even foreign stocks to provide a small return boost through currency differentials but at a smaller scale than we saw in 2017. Our portfolios are overweight U.S. stocks versus foreign stocks, but we will closely watch to see if global stimulus measures like we mentioned earlier could provide additional support to foreign markets trading at a steep discount to the U.S.
Bonds: Our 2018 Outlook advised that a best case bond scenario for 2018 would be to keep your coupon. This played out as interest income was offset by falling bond prices leaving bond total returns hovering near 0%. A flat yield curve with a neutral interest rate outlook should provide bond investors with 2019 total returns that approximate their interest income somewhere in the 2%-4% range. Lower levels of interest rate volatility support the idea that bonds could once again reclaim their fame as a reliable hedge during bouts of stock market volatility in addition to generating a higher income yield than stocks for the first time in years.
High yield corporate bonds and leveraged loan portfolios carry lower credit quality and oversold in December much like stocks. The chart below graphs the spread or interest rate differential between high yield bonds and Treasury notes. During times of credit stress like the dot com era and 2008, spreads widen as investors demand to be compensated for taking greater risk. This is a story that bears following as the economic cycle lengthens, but for now, investors have an opportunity to receive higher levels of interest income for part of their bond portfolio with low levels of default risk.
Outlook for 2019:
Scenario No. 1: Return to Trend GDP Growth of 2%-2.75% (55% odds)
We think this is the most likely scenario based on current information. Removing some of the risk roadblocks like Fed policy, trade and global growth could contribute to trend U.S. growth and a comeback for global economies after their 2018 slowdown.
Scenario No. 2: Soft Landing with 1%-1.75% GDP Growth (40% odds)
First quarter 2019 may feel like a soft landing due to the government shutdown but is likely to be transitory as 2019 progresses. We remain aware that one of the larger looming risks is the debt-ceiling debate that will occur this summer. Political polarity in 2019 is even stronger than it was during the 2011 standoff between then President Obama and House Speaker John Boehner and is why we assign a not insignificant 40% probability to second half weakness.
Scenario No. 3: Recession with two successive quarters of negative GDP growth (5% odds)
We view this scenario as possible but not probable, therefore the low odds. For this to occur in 2019, we would have to see a perfect storm of policy mistakes, trade wars, economic deterioration and/or geopolitical events.
Baseline: The odds are high that we may alternate between Scenarios 1 and 2 with due respect to stimulus from last year’s tax cuts, the removal of risk headwinds from the Fed and trade but acknowledging both known and unknown risks that can quickly develop.
Asset Allocation Update: “Time is your friend; impulse is your enemy.” – Jack Bogle founder of The Vanguard Group and index fund pioneer
Industry legend Jack Bogle reminded us all that patience can be a virtue even when markets test investors resolve during times of turbulence, like 2018. Just as a seat belt is designed to protect you on a long cross-country drive, asset allocation is an investor’s seat belt designed to provide a smoother ride over longer term horizons. With volatility likely here to stay, remaining buckled up is a good idea.
The most successful investment strategies are those that have the fortuitous benefit of hindsight. After a year like 2018, however, the challenge becomes differentiating winning strategies that did well with the benefit of hindsight with those that could do well with thoughtful foresight.
To demonstrate this concept, the chart below compares and contrasts the S&P 500 stock index (red) versus a well-diversified portfolio (orange) invested across U.S. stocks, international stocks, bonds and cash. For illustration purposes, we’ve separated the time periods into distinct bull and bear phases as well as the entire holding period of 2000-2018.
Takeaway: As we show in the chart above, slow and steady often wins the race with less heartache.
- Diversified portfolios (asset allocation) outperformed during bear markets.
- The S&P 500 outperformed during bull markets.
- Diversified portfolios matched S&P 500 performance over time, with less risk.
The most important message isn’t what happens from time-to-time during volatile markets but what happens over time though a prudent asset allocation process that strives to provide smoother returns with less risk.
This piece is produced by Jeff Terrell, CFA Chief Wealth Market Strategist
BB&T Wealth Portfolio Management Team
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.