Markets have been tossed about on a sea of volatility in the past several weeks as a combination of somewhat weaker economic data, trade and tariff tensions, and now…fears of a government shutdown, which have brought back memories of 2013. After reasonably strong returns earlier in the year, most equity and credit markets are down for the year, with the most negative returns outside the U.S.
For investors, finding something to worry about in this environment is all too easy: tariff tensions are rising, the Fed’s recent meeting suggests 2019 economic growth is slowing (fewer rate hikes may be needed), the surprising news from Federal Express that global trade is slowing, and the crosswinds of other concerns continue to blow. From our perspective, the investment world is moving from great to good — from the bright sunny skies of abundant growth, liquidity and earnings, to partly cloudy skies. We think investors may be better served by focusing on where they are going, rather than the dark clouds ahead.
We continue to believe 2019 will see the evolution of the “good” story — with unemployment still at low levels, slightly higher interest rates, single-digit profit growth and, most importantly, low risk of a recession. However, in the midst of current turbulence, we acknowledge the risk of further downside driven by political instability, ongoing negative earnings revisions and tightening credit markets. In our view, the turbulence has stirred markets to such an extent that pockets of value are starting to appear. For example, the stock market now trades at 14.5 times the very unchallenging 2019 earnings estimate of $170 for the S&P 500.
Some clouds will persist into January, including the likelihood of downward revisions to earnings per share estimates, but we do not expect a recession next year. Credit has rolled over, but it is not signaling recession. We expect banks to continue tightening credit standards through 2019 and markets to continue to reprice credit lower after a multiyear bull market in credit, consistent with a modest economic slowdown from the 3%+ GDP growth rate we expect for 2018.
However, we think the late-December liquidity vacuum, tax-loss selling, and algorithmic and machine trading have magnified already cautious market sentiment from tariff tensions. The result has been liquidation and indiscriminate selling across most asset classes. Indeed, a close read of FOMC Chair Powell’s commentary was more constructive than current market sentiment suggests. Notably, Chairman Powell’s observation that slowdowns happen more gradually than in the past due to structural changes in the economy was ignored while his comment that the pace of Fed balance sheet reduction is unlikely to slow triggered an unjustified negative reaction — which is just noise in our view. Most importantly, the Fed has clearly embraced a fully flexible use of rates to produce a soft landing should data suggest a recession is looming.
Given what we expect to be very strong crosswinds as we come down from great to good, we think investors will continue to benefit from keeping a tight rein on portfolio risk. This includes keeping portfolios well diversified and at the lower end of their long-term risk ranges, and shifting away from index-like strategies toward more active strategies that both manage risk and can uncover the upcoming valuation opportunities in equity and credit markets in 2019.
