The markets experienced a torrent of selling during the final weeks of 2018, the likes of which had not been seen in more than a decade. The pace and breadth of the downside volatility could perhaps be best described as relentless and exhausting. As of the close of trading on December 24, the Dow Jones Industrial Average and S&P 500® had both declined 15% since the beginning of the month, and the NASDAQ had fallen 16%. From their record highs of August and September, these drops were even steeper, with the Dow off 19%, the S&P 500 down 20%, and the NASDAQ falling 24%. It was the worst single month for stocks since 2008.
We feel it could be helpful to take a look at what we believe to be the root causes of this most recent market decline and our overall perspective on those concerns. First, at the forefront of this brutal selloff, in our opinion, has been a loss of investor confidence across a series of different market criteria. These would include:
The Federal Reserve and future monetary policy. Suffice it to say that following the Fed’s final meeting of the year and Chairman Jay Powell’s subsequent press conference, the market took on the perspective that the Federal Open Market Committee (FOMC) had completely lost touch with current conditions and, as a result, would continue raising rates into a slowing economy, therefore increasing the risk of recession in the upcoming year. This in large part helps to explain the 9% drop in the Dow between midday on December 19 and the close on December 24.
Fears of a recession in the next year. It is hard to believe just a few months ago the markets were worried about a U.S. economy that might be overheating. In the seeming blink of an eye, those concerns have shifted to a mirror image of an economy slowing into potentially negative growth. Culprits behind this flip of fears include not only the perception of the Fed over-tightening financial conditions, but also concerns of an inverted yield curve, declining global growth following disappointing economic results in Europe and China, and the uncertainties surrounding U.S.-China trade relations.
Declining rates of corporate earnings growth for calendar year 2019. There is no question the rate of growth for corporate earnings in the U.S. will be lower in the year ahead than this past one. However, this is something that has been known for quite some time. The year of 2018 was a stellar one for earnings growth as a strengthening economy and the first year of fiscal stimulus from lower tax rates has helped underlying S&P 500 earnings to likely achieve about 20% year-over-year growth. Pretty much nobody expected such growth to continue into 2019. But in the final weeks, it has seemed the markets are now discounting close to no growth whatsoever, which is quite a change from just a couple of months previous.
The ongoing U.S.-China trade dispute and the prospects of more tariffs during the year ahead. While there can be a good bit of debate regarding the effectiveness of tariffs in trade negotiations, it is abundantly clear the market does not like them and shudders at the prospect of more of them being imposed by the U.S. on China and vice versa. Following what looked like short-term tariff détente following the G-20 Summit in Argentina in late November and a potential trade agreement between the U.S. and China to be hammered out by the end of 1Q19, the market has since apparently lost any sense of confidence that a deal will come to fruition, and thus seems to be assuming future tariffs in the year ahead.
Widening credit spreads adding to investor concerns in the corporate bond markets. During the final months of 2018, high-yield credit spreads expanded more than 2% (from 3.2% to 5.3%), BBB spreads increased .82% (from 1.15% to 1.97%), and traditional investment-grade spreads by .64% (from .91% to 1.55%). We believe much of this spread widening and newly found credit concerns surround the fears of economic slowing and/or recession that seemed to gather momentum in the final weeks of the year.
Tax-loss selling as a negative year in stocks conclude.
In addition to these concerns, the market has likely been experiencing a high degree of year-end, tax-loss selling as investors look to realize losses that can be used to offset previous gains. This has probably served to further accelerate price declines.
While we feel all of these investor concerns are legitimate in their foundation, we also believe the markets are now discounting close to a worst-case scenario for all of them and giving little to no probability that better or less drastic outcomes might result. For that reason, we think the market may well be quite oversold at this point.
We would therefore like to provide the following perspectives.
- Despite the extreme negative reaction by the market following the Fed’s most recent December meeting, we do not expect overly hawkish or out-of-touch monetary policy in the year ahead. We believe the Fed probably takes a pause on any further rate hikes during the first half of 2019 before potentially resuming more hikes in the second half of the year after there is greater clarity on the economy.
- We do not see the U.S. economy at any imminent risk of a recession in the upcoming year. Following what will likely be about 3% GDP growth for CY18, we believe the economy is capable of mid-2%-type growth in 2019 based on continued low unemployment, solid consumer spending trends, and higher overall wage growth, which in our opinion could still provide a favorable backdrop for investors.
- We still believe corporate earnings growth can reach mid-to-high single digits in the year ahead, which could allow for stock appreciation of about the same level. Following the exceptional earnings growth of 2018, comparisons are difficult in the upcoming year. However the potential of a growing economy, decent corporate margins, and continued share-buybacks seem to be setting the stage for decent profits growth in 2019, perhaps in the 5%–9% range. In addition, valuations are now at less than 14 times S&P 500 2019 estimated earnings, and this appears to be providing an attractive entry point on such earnings prospects.
- The ongoing U.S.-China trade dispute is the biggest wildcard for investors in the year ahead, but it is also the easiest to be resolved. The uncertainties surrounding this trade friction and the fears of ongoing or escalating tariffs have certainly put markets on edge over this past year. However, we believe that at its core this is a market risk created by human beings and therefore through negotiations, human beings can potentially resolve it. Should this risk actually be resolved or significantly mitigated through the cancelation of existing tariffs, or at least the elimination of future ones, there could be real upside for stocks.
- Credit spreads are now accounting for meaningful compensation of current market risks, and this provides opportunities for bond investors. Given the extent of the recent equity selloffs, we view the corresponding expansion of credit spreads as expected and believe fixed-income investors can achieve these higher coupon returns via higher quality segments of the corporate bond markets.
In summary, these past few months have seen selloffs in stocks beyond the basic garden variety market corrections, and the final weeks have reached steep declines not seen since the previous decade. However, we believe while a series of legitimate investor concerns created the original selling, an undue sense of pessimism and negativity has materially exacerbated it. Therefore, we feel that potential resolutions to some — if not most — of these concerns could be setting the stage for upside to the equity and credit markets in the year ahead.
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