- 2018 was a surprisingly tough year in the face of strong US economic conditions
- We think two primary catalysts are needed for equities to move higher: a Fed pause and a US/China trade resolution
- We are modestly overweight equities to fixed income in Tactical models
As we consider what was written about the outlook for 2018 one year ago, it is remarkable to reflect on how things have changed. Consider a few headlines from our Review/Outlook piece last year, published on January 8, 2018:
- “By any measure, 2017 was an exceptional year for investors. Virtually every major asset class advanced in 2017 and investors around the world were optimistic as a “global synchronized” economic rally has unfolded. U.S equities returned 21.8% in 2017 as measured by the S&P 500 Index while Emerging Market equities was the top asset class with the MSCI EM Index returning 37.3%.”
- “Coming off a record year of low volatility, the biggest worry many investors have entering 2018 is the shocking degree to which there is (virtually) nothing to worry about!”*
- “2017 was extraordinary in that in was the ONLY year on record where the S&P 500 Index didn’t experience one negative month. The S&P 500 experienced only a 2.8% drawdown over the year, the smallest intra-year decline in 20 years.”*
It’s clear that conditions have drastically changed entering 2019 as capital markets saw large drawdowns in most asset classes in 2018. There is also little debate that economic risks are higher today than what was perceived to be the case a year ago. As a discounting mechanism, equities declined for good reason later in 2018. The most prominent worries among investors are: 1) fears of slowing global growth, 2) fears that the Federal Reserve has or will go too far in raising interest rates and ongoing “Quantitative Tightening” and 3) trade instability initiated by the Trump Administration that shakes confidence and corporate supply chains. Regarding the political front, the impending departures of Chief of Staff John Kelly and Secretary of Defense James Mattis have unnerved some investors in a climate where there is already talk of an attempted impeachment with the upcoming split Congress. In repricing these risks, the S&P 500 Index experienced it’s third largest Q4 decline in history in 2018 at -13.5%1. There is little question that volatility is back and back with a vengeance entering the new year!
A review of asset classes for the 4th quarter and calendar year show that there was scant place to hide in 2018. According to Deutsche Bank, about 90% of the 70 asset classes they track saw declines for the year.4 Below are selected index return data:
It is ironic that the recent drawdowns occurred in the face of strong domestic earnings and economic growth in the U.S. for much of 2018. For example, the Federal Reserve forecast for Real GDP growth was +2.5% for 2018 coming into the year compared to the +3.0% forecast today. S&P 500 earnings are also expected to grow by 22%2 (boosted by one-time tax cuts). Further, strong revenue growth of 8.9% for S&P 500 companies are expected for 2018, which would be the highest annual growth rate since early in the current recovery in 20112. It was also a record year for share buybacks as U.S. corporations repurchased over $800m of the announced $1.1 trillion in 20183. For some time, we at Fundamentum have been concerned about the setup of “it’s as good as it gets” in the face of very strong economic data and relatively expensive valuation levels. However, after the Q4 selloff, we are now left with the question of whether capital markets have gone too far in discounting something (i.e., recession) that is unlikely to occur in 2019.
In our view, there are two primary catalysts listed below that must occur to reverse the current pessimistic sentiment that dominates markets entering 2019.
- A resolution on US/China trade relations
- A pause in interest rate increases and monetary tightening by the Federal Reserve
We think some resolution needs to be reached with China early in 2019 or policymakers run the risk of markets pricing further slowing in economic output in both the US and China. Recent economic activity readings such as manufacturing data out of both countries have shown sharp decreases. Clarity of policy and elimination/reduction of imposed and proposed tariffs are likely needed to reduce uncertainty and lower the impact on supply chains and corporate profits.
We also think the Federal Reserve needs to pause overall monetary tightening in early 2019. The Fed currently projects two additional rate hikes in the year while market expectations now price in no movement at all. By the shape of the yield curve and recent market declines, it is clear investors believe there is high risk of a Fed policy error. While rate cuts may not be necessary to change sentiment, a “pause” in the hiking cycle and perhaps the balance sheet reduction is likely necessary for investors to not assume the worst. Finally, a Fed pause might help induce a stabilization of economic conditions in China and the Eurozone.
Avoiding a recession or conditions that look like a recession in the U.S. is paramount in 2019 from our view. We think these two catalysts are important and necessary to reduce the risk of an economic or earnings recession. We expect economic data, both hard and soft, as well as earnings expectations to continue weakening over the coming weeks. However, the question today is the magnitude of the decline and what exactly the market is discounting into 2019. We respect the message the market is sending as it’s true that all recessions were preceded by substantial declines in equities. But it’s also true that since 1945, the S&P 500 Index has declined by 15% or more EIGHT times without a recession following.1 We had a similar experience as recently as 2015-16 as we do today with worries over global growth, a collapse in oil prices, a substantial spike in credit spreads, which resulted in a similar contraction in PE ratios as today. However, certain policy responses (Fed pause, China stimulus) enacted prevented the onset of recession. After some pressure early in the year, U.S. equities went on to have a solid year in 2016, advancing about 12% as economic conditions stabilized. We will see if upcoming policy responses are similarly stimulative to risk assets in 2019.
While we are a bit concerned about current expectations for S&P 500 earnings growth of 7.4% in 20192, we believe there is enough momentum left in the cycle to warrant another year of economic growth with some earnings gains should we get the policy action described. We recognize that the Federal Reserve has raised the Fed Funds rates nine times this cycle, but the current real Fed Funds rate of +0.25% is far below levels that brought on recessions in the past (levels closer to +2.0% real Fed Funds rates1). Even factoring in ongoing reductions in the Fed’s balance sheet, monetary policy is far from restrictive in our opinion (although we need a pause!). Another positive tailwind is the remaining Fiscal stimulus from the 2017 Tax Cut Act, though less impactful in 2019 than it was in 2018. So, given reduced valuation levels of 14.1x 2019 estimates for the S&P 500 Index2, we think equities may respond positively if these catalysts occur coupled with other prevailing tailwinds, assuming the U.S. does not enter a recession.
Putting it all together, we believe the likelihood of getting positive policy responses that keeps the US economy out of recession is high enough that we are sticking with our current modest overweight to equities vs. fixed income entering 2019. In an upcoming report, we will discuss portfolio positioning of the Fundamentum strategies in more detail and provide an attribution summary of our 2018 performance. Until then, it’s probably best to turn off CNBC as the manic nature of markets can be unnerving. We’re watching!
Fundamentum Investment Committee
Chad Roope, CFA-Portfolio Manager
Paul Danes, CFA - Investment Committee
Trevor Forbes - Investment Committee
Matt Dunn, CFA - Chief Compliance Officer
1 Strategas – 1/2/19
2 Factset Earnings Insights – 1/4/19
3 JP Morgan Asset Management Guide to the Markets – 12/31/19
4 Wall Street Journal – 11/26/19
5 Morningstar Direct – 1/4/19
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