A Year of Uncertainties
U.S. equities, as measured by the S&P 500 are officially below correction territory with the S&P 500 declining 14.76% from its all-time high on September 21, 2018 and down 6.23% year-to-date. U.S. small cap stocks, as measured by the Russell 2000, are in a bear market down 22.55% from their all-time high on August 31, 2018 and down 12.13% year-to-date. Global equity markets, ex-U.S., are down 16.38% year-to-date as measured by MSCI. Even U.S. Treasuries are down 0.8% year-to-date.
Along with drops in global equity markets, volatility has returned causing the seemingly wild intra-day moves that markets are currently enduring. However, according to Cliff Asness of AQR, what might be viewed as abnormal market swings are actually only slightly above normal. “Annualized daily volatility of the S&P 500 as of December 17, 2018 is 16.5%. That puts it at the 66th percentile over history going back to 1928.” That is slightly higher than usual yet what many people may remember is the lack of volatility in 2017 when daily annualized volatility was 6.9%. 2017 was an historic market year in terms of the lack of volatility, not necessarily the above average equity returns. We have written about this previously but I would direct you to his post here.
The questions many people are asking currently is what is wrong with equity markets and is the U.S. economy headed towards a recession?
When assessing the stock market and the economy, investors often confuse the two for being one in the same. The stock market is often a leading indicator for the economy but is not always correct and they are certainly not interchangeable. The stock market has been signaling that a recession in the U.S. may be imminent yet underlying data within the economy has not justified this quite yet. There are several factors signaling that there may be a slowdown in the rate of growth coming but data pointing to a recession in the U.S. is not yet evident. The housing and equity markets are the two areas showing initial signs of a slowdown, yet industrial production remains strong and the consumer appears to be in good health. Inflation is relatively stable and GDP is expected to continue to grow albeit at a slower pace through 2019. Credit Suisse, in the Wall St. Journal, states that while “Economists expect a slowdown, they are not expecting a recession.” Dr. David Kelly from JP Morgan compared it to an aging runner saying that the “Data is good and will allow the economy to run, but it will be slower and susceptible to injury.” Despite the “runner” analogy Dr. Kelly believes that U.S equites remain attractive and developed international equities may be even more attractive based on relatively low valuations.
Long-term fundamentals and valuation within U.S. equity markets appear attractive. The 2019 forward P/E for the S&P 500 currently at 14.3x which is below the 25-year average of 15.5x. There has been strong earnings growth among S&P 500 companies in 2018 and should earnings growth continue in 2019 at a more moderate rate; analysts are predicting earnings growth between 8-10% and S&P 500 returns between 5-6%.
The big news from Wednesday was the FOMC continuing its path of rate normalization by increasing the Federal Reserve Fed Funds target rate by 25 bps to an upper range of 2.50%. Markets were expecting this continued hike but are concerned about future hikes in 2019 and fell during the Federal Reserve Chairman Jerome Powell’s speech. Low interest rates have helped boost asset prices for the better part of 10 years now which will cause more market volatility into 2019. JP Morgan fixed income strategist Alex Dryden compared the Fed’s decision to “taking the training wheels off” when teaching a child to ride a bike. There may be increased uncertainty in the market initially, but the Fed understands that a healthy economy should be able to operate under these normalized interest rates. After the Federal Reserve decision yesterday, the Federal funds rate will have a range of 2.25-2.50% and the Federal Reserve is targeting normalized rates between 2.50-3.50%. Just as removing the training wheels on a bike may cause some scary moments at first, a child must face that fear in order to learn to ride a bicycle and will be better for it over the longer-term.
Global economic data and oil prices are also beginning to weigh on the markets. Crude oil prices are below $50/barrel causing concerns that global demand is slowing down along with the economic data. Falling oil prices have proved detrimental to equity markets yet should provide a boost to the U.S. consumer. Economic numbers out of Europe are showing that a slowdown is underway in many of the developed economies. China reported its slowest retail sales growth in 15 years and its weakest factory output in three years.
Much of this is being attributed to the ongoing trade tensions between the U.S. and the rest of the world. The elephant in the room is obviously the ongoing trade negotiations with China but negotiations continue on tariffs with the European Union along with the “New NAFTA” deal between the U.S., Canada and Mexico. There appears to be some short-term progress in all of these areas yet global markets are looking for long-term solutions and until one is reached, especially with China, trade tensions will continue to be a drag on growth.
Political unrest in Europe and uncertainty in the U.S. is also spooking markets. Protests continue for the fourth week in France over government reforms and anti-establishment protests have also broke out in several other countries including Belgium, Hungary and Sweden. Fears of inflation due to a “hard Brexit” without any trade agreement continue to mount as the UK moves forward with leaving the European Union. In the U.S., the Mueller investigation into Donald Trump’s presidential campaign marks uncertainty around his future. Congress, along with the President, are attempting to avoid another government shutdown.
Investing in the markets currently is flush with uncertainty, both economic and political. It can be assumed that 2019 will begin with much of these uncertainties remaining yet the recent sharp sell-off in equity markets may be more a result of a breakdown in technical data, combined with an overwhelming negative sentiment, than a fundamental problem in the U.S. economy and equity markets. As we previously stated, long-term valuations and fundamentals for both the markets and economy appear attractive. It is important to remember the long-term horizon of stocks rather than be hyper-focused on short-term returns (i.e. each year). We continue to stress that remaining invested in the markets for the long-term is a better strategy than attempting to time the markets. If you have not read Scott Sr.’s post from last week, I would encourage you to do so here.
As always, if you have any questions or would like to review your portfolio, please do not hesitate to call us and schedule a meeting or speak with us on the phone. We appreciate the confidence you place in us and hope that you all have a very happy, healthy holiday season.
*All data is as of 12/19/2018