2018 marked the return of more typical volatility to global equity markets. During 2018, U.S. equity markets (as measured by the S&P 500) endured five separate swings of 10% or more both higher and lower. This is in stark contrast to the abnormal 2017 where the S&P 500’s largest decline was a paltry 3%.
When thinking about 2018, we can really divide the year into two very distinct segments. For the first three quarters, U.S. equity and bond markets as well as the economy performed pretty much as forecast. Our key pillars of employment, earnings and economic growth all performed admirably (both for the nine months as well as for the full year). Employment has now increased for 100 straight months, S&P 500 earnings will likely end 2018 by posting a whopping 23% rise while U.S. economic growth has been the strongest for many years (albeit pumped up by several transitory items). All this prompted the S&P 500 to increase by 10.6% through September 2018. Given solid economic growth, the 10-Year U.S. Treasury bond yield rose to a high of 3.25% from 2.47% at the start of the year. Incidentally, up until the 4th quarter, both U.S. stocks and bonds performed right in line with our beginning of 2018 forecast letter and we were feeling pretty good about ourselves.
And then the 4th quarter happened….Specifically, on October 3rd Federal Reserve Chairman Jay Powell strongly indicated that the Fed was still planning to raise interest rates in an almost robotic fashion by perhaps 100 basis points or more. There were two main problems with this statement: 1) early signs of an economic moderation were appearing in the data and 2) the perception that the Fed was on auto-pilot in their approach rather than being data dependent. U.S. equity and bond market reactions were swift. The S&P 500 corrected by 11.4% at its October low and bond yields started to rapidly decline. As the quarter continued, the rift between Fed expectations (or maybe just Fed communication) and investor expectations for economic growth continued to widen. Investor sentiment deteriorated rapidly exacerbated by political / trade uncertainty reaching its peak negativity just before Christmas. At its worst, the S&P 500 suffered a 20% correction before rebounding before the end of the year. The correction ended up wiping out 2018 gains and the S&P 500 declined by 4.4% for 2018 while the 10-Year U.S Treasury yield rose 22 basis points from 2.47% to 2.69%.
On the international front, 2018 was a poor year for international equities. Developed global economies could not gain much traction and are still stalled. Political developments in Great Britain, France, Italy and Spain have all conspired to restrict progress. Emerging market economies in general and China in particular have probably been most impacted by trade war disruptions. As a result, developed international equity markets and emerging international equity markets declined by 13.8% and 14.6%, respectively.
2019 Market Outlook
In December we discussed that the disconnect between the Federal Reserve’s and investors’ economic outlooks would eventually be resolved as economic data is released. As reality reveals itself the rift will close. Of course, the key question for 2019 will be whether the Fed’s optimism or investor pessimism will prove correct. The most likely answer lies somewhere in between. In fact, during the first week of 2019, we have already seen a couple of data points to support this viewpoint. First, the most recent employment report showed strong job gains thus easing, for now, investor concerns over potential recession. Second, Fed Chairman Powell acknowledged that it would be paying closer attention to other worsening economic statistics thus implying that the Fed’s rate hikes were on pause if the economic data does indeed prove to be weak. So, while we are only one week into the new year, the disconnect has already started to shrink and, as a result, markets have begun the year on a solid, if volatile, note.
In terms of our expectations for 2019, our base case calls for the U.S. economy to slow to below trend growth but, importantly, that a 2019 recession is unlikely. This is based on our assumptions that the economy should still grow, employment should continue to rise and corporate profits should continue to advance - albeit at a slower pace than 2018. If we are correct then it is likely that the 4th quarter correction was too severe and our outlook for the equity markets would be positive.
One wildcard to our forecast relates to trade. The uncertainty surrounding the outcome on trade negotiations has disrupted the normal decision-making process of corporations making it impossible for businesses to understand their future cost structure and supply chain. Should the trade war with China intensify the near-term economic impact would be incrementally negative. However, should some kind of deal be reached we would expect a positive economic impact.
Our forecast for U.S. equity returns in 2019 is somewhat below historical average annual returns. We anticipate that the S&P 500 will gain 5%-10% in 2019. We acknowledge that the forecast range is wide but a lot of uncertainty still remains. The key message here is in direction – up. In order to arrive at this forecast we first remind you that the employment picture is still positive and we continue to expect job gains throughout 2019. As you are well aware, there is a very high correlation between rising employment and a rising stock market (despite the 4th quarter of 2018). Also supportive is our outlook for earnings growth of 4%-5%. While a long way from the 23% 2018 earnings growth figure, it is still positive.
Given that our equity forecast is above our expectation for earnings growth, we are necessarily forecasting some modest valuation expansion (unlike our forecasts of the last several years). We feel comfortable with this expectation since the 4th quarter correction brought the S&P 500 PriceEarnings ratio (P/E) down to 15 times our 2019 earnings expectation. Given that this is at the bottom end of the typical 14x-18x valuation range (thanks to strong 2018 earnings coupled with the 4th quarter correction), a little valuation expansion would be quite reasonable.
A word of caution on valuations – for many years we have been comfortable with valuations towards the upper end of the typical range because very strong earnings growth expectations have been quite visible and odds of a recession were low. While we do not expect a recession in 2019, earnings are clearly slowing and, by definition, every day that goes by brings us one day closer to the next recession. As a result, we believe it unlikely that the S&P 500 will sustainably trade at the high end of the valuation range unless the market gains confidence that economic and earnings growth will continue unabated for many years to come.
Turning to international equity markets, we expect returns for 2019 to be similar to those in the United States. While we acknowledge cheaper valuation levels as well as the potential for a greater rebound should the environment stabilize, we do not want to emphasize international equity investment just yet given their more uncertain economic outlook.
On the U.S. bond front, given that we expect economic growth to moderate, for inflation to remain under control and the Fed to be mostly on hold, we believe that the 10-Year U.S. Treasury bond yield should trade in a range of 2.5%-3.1% after closing 2018 at 2.69%.
Translating all of this into our strategy results in a somewhat conservative approach for 2019. Based on our current outlook, we will look to continue to bias portfolios to be less aggressive compared to typical equity targets (individual strategies will vary based on capital gains limitations and other client-specific considerations).
Of course, despite all of our best laid out thought process, events through 2019 will likely conspire to force us to alter our thinking in one direction or another. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy and Successful 2019!
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