17 Dec 2018
Market Expects Higher Volatility and More Violent Moves with 2019 Approaching
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. 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 in late November 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. Following those recent comments from Powell, expectations for 2019 rate increases fell and now only one rate hike is expected next year.
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.
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.
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.
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.
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Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
The Institute for Supply Management Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation, by the Institute of Supply Management (ISM). The ISM Non-Manufacturing Index tracks economic data, like the ISM Non-Manufacturing Business Activity Index.
The Bloomberg U.S. Financial Conditions Index provides a daily statistical measure of the relative strength of the U.S. money markets, bond markets, and equity markets, and is considered an accurate gauge of the overall conditions in U.S. financial and credit markets.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research