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Risk Remains and Volatility is Likely to Persist in the U.S. Stocks

Stocks have staged a nice rebound following the sharp selling that culminated on Christmas Eve. It seems clear that market dynamics have changed somewhat, from the “sell first, ask questions later” attitude that dominated last year’s final quarter; with the tenor of the post-Christmas rally fairly healthy from a breadth standpoint. Many individual stocks are still getting punished for genuinely bad news—such as a few retailers recently on weaker-than-expected holiday results—but for now those concerns have not translated into broader economic or stock market carnage. While more positive, all is not clear in our view and obstacles to a sustainable uptrend remain in place. There have been some positive developments in the China/U.S. trade dispute but a deal remains elusive; the Federal Reserve has backed off some of the more hawkish rhetoric, but the risk of a monetary mistake remains; Brexit remains a major uncertainty; and the U.S. government hasn’t done a lot to inspire confidence recently, with its record-breaking shutdown.

Trade, economic, monetary policy, and earnings risks are what led us to move to a modestly defensive investment posture last year, reducing our rating on emerging markets, while moving to a slightly defensive posture with our sector views. But our view that volatility would bring sharp moves in both directions is why we didn’t go to a more drastic defensive stance. We continue to believe that the odds of a U.S. recession in the near-term are fairly low; however, trade will likely provide guidance as to the length of runway between now and the next (inevitable) recession.

Economic growth slowing, but not drastically yet

There is little doubt economic growth is downshifting as 2019 gets underway. Both the manufacturing and services Institute for Supply Management (ISM) surveys declined over the past month, with the New Orders component of the Manufacturing Index (a forward looking indicator) falling sharply to 51.1—dangerously close to the 50 dividing line between expansion and contraction.

Earnings season on deck

We’ll get more information on this mixed economic picture in the next few weeks as fourth quarter 2018 earnings season ramps up. Consensus expectations have been cut over the past couple of months according to Thomson Reuters, but the “beat rate” is expected to be much less than the norm. Forward guidance will be important as well given the slashing that’s been done to 2019 estimates relative to 2018’s tax cut-related growth. Commentary on capital expenditure plans, consumer behavior, and trade impacts will all be of interest—both in how they are affecting actual results, but also sentiment as we look to future quarters.

Fed changes tack…but not the Federal government

The decline in business confidence, combined with the sharp fourth quarter 2018 drop in equities, appears to have pushed the Federal Reserve to “clarify” its position on the rate outlook. Fed speakers as of late, including Chairman Jerome Powell, appear to have gone out of their way to emphasize that they have no preset course and that patience is warranted. However, expectations for no additional rate hikes may need to be adjusted if we get another couple of strong jobs reports; especially if they include hotter wage growth.

Brexit: what’s next?

Next steps for Brexit continue to evolve. It seems increasingly likely the March 29 exit date may be extended, giving the UK more time to allow for outcomes such as another plan to be put to a parliamentary vote, a narrow deal that covers the settlement of the divorce but leaves a period until December 2020 to define the future trade relationship; or even a second referendum, among others. However, the extension is likely to be short in duration due to European Parliamentary elections scheduled in May.

The UK constitutes 6% of the MSCI World Index and 17% of the MSCI EAFE Index; while the British pound is 12% of the Dollar Index. Some Brexit pessimism had been priced in to both UK stocks and the pound over the past six months; but the gain in the pound in the weeks ahead of the vote may imply some hope that the worst case of a disorderly Brexit may be avoided. If the exit date is extended past March 29, to allow for outcomes that avoid a disorderly Brexit, markets could continue to rebound. But that could succumb to further volatility as the way ahead seems unlikely to be straightforward. After all, Brexit has been characterized by the unexpected since the referendum in June 2016.

So what?

U.S. stocks have staged a nice rally to start the year but we don’t believe it reflects an all-clear sign. We continue to recommend investors adopt a highly-disciplined approach to asset allocation, especially around diversification and rebalancing. Risks to both the U.S. and global markets/economy remain, and we expect continued bouts of volatility.


Important Disclosures
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

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 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 MSCI World Index is a stock market index of 1,642 'world' stocks. It is maintained by MSCI Inc., formerly Morgan Stanley Capital International, and is used as a common benchmark for 'world' or 'global' stock funds. The index includes a collection of stocks of all the developed markets in the world, as defined by MSCI. The index includes securities from 23 countries.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

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

Content provided by Charles Schwab, Hong Kong
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